Problem $6-9$

Term structure A one$-$year Treasury bill currently offers a $\backslash (5\backslash \%\backslash )$ rate of return. A two$-$year Treasury note offers a $\backslash (5\mathrm{.}5\backslash \%\backslash )$ rate of return. Under the expectations theory, what rate of return do investors expect a one$-$year Treasury bill to pay next year?

Solution

Consider two $2-$year investment options: $($i$)$ a $2-$year bond offering $5\mathrm{.}5\backslash \%$ or $($ii$)$ a $1-$year bond offering $5\backslash \%$ and another $1-$year bond in $1$ year. Under the expectations theory of the term structure, the options should offer the same return.

Alternatively,

$($ii$)$