Suppose that you could buy a one-year bond today, which has an interest rate of 3%. If you wait a year and buy a one-year bond then, the interest rate will be 4%. Two years from now, a one-year bond is expected to offer an interest rate of 5%
According to the expectations theory of the term structure of interest rates, what is the interest rate on a two-year bond today? What is the interest rate on a three-year bond today?
Two-year bond: (3% + 4%)/2 = 3.5%; Three-year bond: (3% + 4% + 5%)/3 = 4%.
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