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Answer: 3.5%
Under the pure expectations theory, the two-year spot rate is the average of the current one-year spot rate and the expected one-year forward rate for year 2: $$2r(0,2)=r(0,1)+f(1,2)$$ So: $$2r(0,2)=3.0\%+4.0\%=7.0\%$$ Hence: $$r(0,2)=3.5\%$$ **Correct answer: B. 3.5%**
Author: Manit Arora
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Question 162.1.
The one-year zero rate (spot rate) is 3.0% per annum with continuous compounding; i.e., . The market consensus is that this rate will increase to 4.0% in the next year; i.e., the consensus expected future zero (spot) rate is 4.0%, one year forward. Under the pure EXPECTATIONS THEORY of interest rate term structure, what is the current two-year zero rate, ?
A
Less than 3.5%
B
3.5%
C
More than 3.5%
D
Unclear from information given
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