Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

a. 7.36%

b. 8.59%

c. 7.75%

d. 8.16%

e. 9.04%

9.04%

Explanation:

The computation of the market forecast for 1 year rate from now is shown below:

(Face value of bond * 1 + interest rate) * (1 + X) = (Face value of bond * 1 + interest rate) ^number of years

Let us assume the face value of bond be 1

And, the X is the rate for one year

So,

(1 * 1 + 0.05) * (1 + X) = (1 * 1 + 0.07) ^2

(1.05) * (1 + X) = 1.1449

After solving this, the X = 9.04%