Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now

6.20%

Explanation:

The computation of the yield on a 1 year T bond is shown below:

Yield expected to be one year from now = yield on 2 year bond

where,

Yield expected to be one year from now is

= (1 + 0.05) (1 + yield expected one year from now)

And, the yield on 2 year bond is

= 1 + (5% - 0.4%) ^2

= (1 + 5.6%) ^2

= 1.11514

Now equate this above two equations

(1 + 0.05) (1 + yield expected one year from now) = 1.11514

After solving this,

Yield expected one year from now is 6.20%