Explanation:
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:
2`r(0,2)=r(0,1)+f(1,2)$$
So:
2`r(0,2)=3.0%+4.0%=7.0%$$
Hence:
Correct answer: B. 3.5%
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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