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28 January, 23:11

Interest rates on 3 year treasury securities are currently 7%, while 5 year treasury securities yield 8%. If the pure expectations theory is correct what does the market believe that 2 year securities will be yielding 3 years from now?

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  1. 28 January, 23:17
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    9.52 percent on annual compounding assumption

    9.509 percent on semiannual compounding assumption

    Explanation:

    Based on annual compounding assumption

    Yield on three year security = 7%

    Yield on five year security = 8%

    If the markets are in equilibrium, the yield on two years security three years from now should be as under

    [ (1+0.08) ^5 / (1+0.07) ^3]^ (1/2) - 1

    [1.46933/1.225]^0.5 - 1

    1.0952 - 1 = 0.0952 or 9.52%

    Based on semiannual compounding assumption

    Yield on three year security = 3.5%

    Yield on five year security = 4%

    If the markets are in equilibrium, the yield on two years security three years from now should be as under

    [ (1+0.04) ^10 / (1+0.035) ^6]^ (1/4) - 1

    [1.4802/1.2292]^0.25 - 1

    1.04755 - 1 = 0.04755 = 4.755% semiannual

    4.755 x 2 = 9.509%
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