(a). Concept Introduction: Treasury bonds (T-bonds): These bonds involve earning periodic interest up to maturity (greater than 20 years) and consider government debt securities that are issued by the Federal government of the country. Expectations theory: Based on long-term (current) interest rates this theory, forecasts the short-term interest rates for the future where an investor receives the same amount of interest by investing in two (one-year bond and two-year bond), one after the other year. It is useful to calculate the expected returns and differentiate the investment returns in business. To determine: The expected one-year interest rates in the second year by using the expectation theory when the interest rate on one-year treasury bonds is 1%, 0.9% on two-year bonds, and 0.8% on three-year T-bonds. The expected interest rates in the second year would be 0.95%. As there would be the same ending value by using the expectation theory, therefore, in the given situation, at the two years rate, the ending value of investing for two years would be the same as one year. The formula to calculate expected interest rates will be, Expected interest rate = 1 Year × First-year interest rate + 1 Year × Second-year interest rate Calculation of expected interest rate is as follows: Expected interest rate = 1 2 1 % + 1 2 0.9 % = 0.5 % + 0.45 % = 0.95 % Hence, the expected interest rate will be 0.95%. (b). Concept Introduction: Treasury bonds (T-bonds): These bonds involve earning periodic interest up to maturity (greater than 20 years) and consider government debt securities that are issued by the Federal government of the country. Expectations theory: Based on long-term (current) interest rates, this theory forecasts the short-term interest rates for the future where an investor receives the same amount of interest by investing in two (one-year bond and two-year bond), one after the other year. It is useful to calculate the expected returns and differentiate the investment returns in business. To determine: The expected one-year interest rates in the third year by using the expectation theory when the interest rate on one-year treasury bonds is 1%, 0.9% on two-year bonds, and 0.8% on three-year T-bonds. The expected interest rates in the third year would be approximate 0.9%. The formula to calculate expected interest rates will be, Expected interest rate = 1 Year × First-year interest rate + 1 Year × Second-year interest rate Calculation of expected interest rate is as follows: Expected interest rate = 1 3 1 % + 1 3 0.9 % + 1 3 0.8 % = 1 3 1 % + 0.9 % + 0.8 % = 1 3 2.7 % = 0.899 % Hence, the expected interest rate will be 0.89%.

EBK CFIN

6th Edition

ISBN: 9781337671743

Author: BESLEY

Publisher: CENGAGE LEARNING - CONSIGNMENT

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