Explanation

In the Ho-Lee model, the expected short-term interest rate at time t is given by:

E[r(t)] = r(0) + θ(1) + θ(2) + ... + θ(t)

Where:

• r(0) is the current short-term interest rate
• θ(t) is the interest rate drift in period t

Given:

• Current short-term interest rate r(0) = 5.4%
• Interest rate drift in period 1: θ(1) = 25 bps = 0.25%
• Interest rate drift in period 2: θ(2) = -10 bps = -0.10%
• Time step dt = 1

Expected short-term interest rate in two periods: E[r(2)] = r(0) + θ(1) + θ(2) E[r(2)] = 5.4% + 0.25% + (-0.10%) E[r(2)] = 5.4% + 0.25% - 0.10% E[r(2)] = 5.55%

Note: The long-run mean reverting level (15.1%) and long-run true interest rate (12.6%) are not needed for this calculation in the Ho-Lee model, as the model uses the calibrated drift terms directly rather than mean reversion parameters.

Therefore, the expected short-term interest rate in two periods is 5.55%, which corresponds to option C.