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8 June, 08:31

Assume that the current interest rate on a one-year bond is 8 percent, the current rate on a two-year bond is 10 percent, and the current rate on a three-year bond is 12 percent. If the expectations theory of the term structure is correct, what is the one-year interest rate expected during Year 3? (Base your answer on an arithmetic average rather than a geometric average.)

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  1. 8 June, 11:48
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    16%

    Explanation:

    Given that,

    Current interest rate on a one-year bond = 8 percent

    Current rate on a two-year bond = 10 percent

    Current rate on a three-year bond = 12 percent

    One-year interest rate expected during Year 3:

    = Current rate on a three-year bond - Current rate on a two-year bond

    = (3 * 12%) - (2 * 10%)

    = 36% - 20%

    = 16%
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