Business, 06.05.2020 03:19 willveloz4

According to the expectations hypothesis (EH), long-maturity yields reflect expectations about future short-maturity yields. Suppose the EH is false. Specifically, suppose that (1+Y(2))^2 > (1+Y(1))*(1+E[Y(1)]), where the expectation is for next year's one-year rate. What can you conclude?a. Investors are not risk-neutral or some other assumption behind the EH does not hold. b. There is an arbitrage opportunity of buying the two year-bond (lending for two years), while also selling the one-year bond today and selling next year’s one-year bond next year (borrowing today for one year and repaying in ayear by borrowing for another year).c. There is an arbitrage opportunity of selling the two year-bond (borrowing for two years), while also buying theone-year bond today and buying next year’s one-year bond next year (lending today for a year and lending again ina year for one more year).d. All of the above.

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