ch 6 video lesson 2 /7

Option 1: Buy a 2-year security and hold it for 2 years. Option 2: Buy a 1-year secuifty, hold it for 1 year, and then at the end of the year reinvest the proceeds in another 1 -year security. In two years, Option 1 will yield the following amount per $1 you invested: Yirld at the end of your 2=$1(1+0.055)2=$1.113 The pure expectation theory implies that Option 2 should vield the same amount, which can be expressed as follows: Yicld at the end of year $=$1(1+0.05)(1+x)=$1.113, where x stands for the expected interest rate on a 1-year Treasury security 1 year from now. 0.0600958,or6.00298% Suppose your friend is deciding between investing in two consecutive 1-year Treasury bonds and a 2-year Treasury bond, The vield on a 1-vear. bond is 4.10% tofay and the yield on a 2-year bood is 5.40%. You tell your finend that if the expected interent rate on a 1 -year bond 1 vear from now is then hi shoutd be fndifferent Detween the two options