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20 April, 17:24

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now

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  1. 20 April, 17:42
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    6.20%

    Explanation:

    The computation of the yield on a 1 year T bond is shown below:

    Yield expected to be one year from now = yield on 2 year bond

    where,

    Yield expected to be one year from now is

    = (1 + 0.05) (1 + yield expected one year from now)

    And, the yield on 2 year bond is

    = 1 + (5% - 0.4%) ^2

    = (1 + 5.6%) ^2

    = 1.11514

    Now equate this above two equations

    (1 + 0.05) (1 + yield expected one year from now) = 1.11514

    After solving this,

    Yield expected one year from now is 6.20%
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