Question 3

3) Suppose r0,1 = 5%, r0,2 = 4%, r0,3 = 4.5%, and that the expectations hypothesis holds. What
does this imply about the expected trajectory of the future 1-year rates, E[r1,1] and E[r2,1]?

Yield (%)

Yield Curve
5.50%
5.00%
4.50%
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%

Yield Curve

2
3
Years to maturity

According to the expectations hypothesis (when it holds), forward rates are equal to expected
future corresponding risk free rates. This implies that E[r1,1] and E[r2,1] can be found using the
current given forward rates.
Expected trajectory of future 1-year rate E[r1,1]

(1+ r ) = (1+ r ) (1+ E r )

2

0,2

0,1

1,1

(1+ 0.04) = (1+ 0.05) 1+ E r1,1

2

(1.04)2
- 1 = E r1,1
(1.05)
0.030095 = E r1,1
3.0095% = E r1,1

Expected trajectory of future 1-year rate E[r2,1]

(1+ r ) = (1+ r ) (1+ E r )

3

0,3

0,2

2,1

(1+ 0.045)3 = (1+ 0.04)2 1+ E r2,1

(1.045)3
- 1 = E r2,1
(1.04)2
0.05507 = E r2,1
5.507% = E r2,1