Suppose the yield to maturity on a one-year zero-coupon bond is 8%. The yield to maturity on a two-year zero-coupon bond is 10%. Answer the following questions (use annual compounding):

(a) According to the Expectations Hypothesis, what is the expected one-year rate in the marketplace for year 2?

(b) Consider an investor who only wants to invest for a year. She expects the yield to maturity on a one-year zero to be 6% next year. In which one will she choose to invest for a year: the one-year zero-coupon bond or the two-year zero-coupon bond? [Hint: compare the holding period return for both bonds]

(c) If all investors behave like the investor in (b), what will happen to the equilibrium term structure according to the Expectations Hypothesis?

Answer rating: 100% (QA)

As per expectation theory a Y1 Y22 Yield 2 years Y2 2 108 ... View the full answer