Suppose the interest rate on a 1-year T-bond is [tex]5.00\%[/tex] and that on a 2-year T-bond is [tex]4.10\%[/tex]. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but [tex]0.40\%[/tex] for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

A. 2.80%
B. 2.37%
C. 2.42%
D. 2.88%



Answer :

Certainly! Let's go through the process step-by-step to determine the yield on a 1-year T-bond expected to be one year from now, given the specific conditions.

### Step-by-Step Solution

1. Interest Rates and Maturity Risk Premia (MRP):
- The interest rate on a 1-year T-bond (rate_1yr) is [tex]\( 5.00\% \)[/tex].
- The interest rate on a 2-year T-bond (rate_2yr) is [tex]\( 4.10\% \)[/tex].
- The maturity risk premium for a 1-year T-bond is [tex]\( 0.00\% \)[/tex] (since MRP for 1-year T-bonds is zero).
- The maturity risk premium for a 2-year T-bond (mrp_2yr) is [tex]\( 0.40\% \)[/tex].

2. Adjust the 2-year T-bond interest rate by adding the MRP:
- The adjusted 2-year rate considering the MRP (avg_2yr_rate) is:
[tex]\[ \text{avg\_2yr\_rate} = 4.10 \% + 0.40 \% = 4.50 \% \][/tex]

3. Calculate the average expected 1-year interest rate over the next two years (avg_2yr_rate):
- The average interest rate over the next two years is already calculated above as [tex]\( 4.50\% \)[/tex].

4. Using the formula to find the expected 1-year rate one year from now (expected_1yr_rate_1yr_later):
[tex]\[ \text{expected\_1yr\_rate\_1yr\_later} = (\text{avg\_2yr\_rate} \times 2) - \text{rate\_1yr} \][/tex]
- Substituting the values:
[tex]\[ \text{expected\_1yr\_rate\_1yr\_later} = (4.50\% \times 2) - 5.00\% \][/tex]

5. Performing the multiplication and subtraction:
[tex]\[ \text{expected\_1yr\_rate\_1yr\_later} = 9.00\% - 5.00\% = 4.00\% \][/tex]

Therefore, the yield on a 1-year T-bond expected to be one year from now is:
[tex]\[ \boxed{4.00\%} \][/tex]

From the given choices, none of them explicitly state [tex]\(4.00\%\)[/tex].

### Conclusion:

The expected yield on a 1-year T-bond one year from now, derived from the available data and conditions, is [tex]\(4.00\%\)[/tex].