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Suppose the interest rate on a 1-year T-bond is 1
Suppose the interest rate on a 1-year T-bond is 1.45% and that on a 2-year T-bond is 2.80%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.20% for a 2-year bond. What is the equilibrium market forecast for 1-year rates 1 year from now?
a) 2.3500%
b) 3.0565%
c) 3.7630%
d) 4.1500%
e) 4.5275%
Expert Solution
Expected return on 2 year T-Bond = 2 year T-Bond rate - MRP
= 2.80% - 0.20%
= 2.60%
Compounded Return = (1+2.60%)^ 2
= 1.05268
Equilibrium market forecast for 1-year rates 1 year from now;
=> (1+1.45%)* (1+x) = 1.05268
=> 1.0145* (1+x) = 1.05268
=> 1.0145+1.0145x = 1.05268
=> 1.0145x= 1.05268- 1.0145
=> 1.0145x= 0.038176
=> x= 0.038176/ 1.0145
x= 0.03763 or 3.7630%
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