Unbiased Expectations Theory exercise

1. See the attached Yield Curve (aka Term Structure of Interest Rates) for January 22, 2019. You have $100,000 that you would like to be invested in US Treasuries for 2 years. You can either buy a 2-year security or buy a 1-year security and then reinvest in another 1-year security when the first one matures. What rate would you have to earn on the second 1-year security to make the 2 alternatives equal? What does this tell you about the markets expectations for short-term interest rates? Take it step by step:

1. What is the rate on the 1-year Treasury? _____1.48________%
2. How much will you have after 1 year if you buy a 1-year security? (hint: your original investment plus interest for 1 year) $____________
3. What is the rate on the 2-year Treasury? ______1.41_____%
4. How much will you have in 2 years of you buy that security? (Hint: your original investment plus interest for 2 years) $___________________
5. If you invest for 1 year and then after 1 year reinvest for another year, what rate would you have to earn in order to make the two alternatives equal? Show your work in whatever format makes logical sense to you. ___________%
6. What does the Unbiased Expectations Theory tell you about the markets expectations for short-term interest rates next year?

1. The expectations theory of the term structure of interest rates states that the yields on financial assets of different maturities are related primarily by market expectations of future yields. The expectations theory has occupied a prominent place in both theoretical and policy debates at various times.