# Expected Rate of Interest: expectations theory

Suppose the annual yield on a 2-year Treasury bond is 7.5 percent, the yield on a 1-year bond is 5 percent, k* is 3 percent, and the maturity risk premium is zero.

A) Using the expectations theory, forecast the interest rate on a 1-year bond during the second year (Under the expectations theory, the yield on a 2-year bond is equal to the average yield on 1-year bonds in Year 1 and Year 2)

B) What is the expected inflation rate in Year 1? Year 2?

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#### Solution Preview

Suppose the annual yield on a 2-year Treasury bond is 7.5 percent, the yield on a 1-year bond is 5 percent, k* is 3 percent, and the maturity risk premium is zero.

A) Using the expectations theory, forecast the interest rate on a 1-year bond during the second year (Under the expectations theory, the yield on a 2-year bond is equal to the average yield on 1-year bonds in Year 1 ...

#### Solution Summary

The solution forecasts the interest rate on a 1-year bond during the second year using the expectations theory and calculates the expected inflation rate.