Consider the following $1000 par value zero-coupon Treasury bonds: Bond Years to Maturity Yield to Maturity A 1 4.00% B 2 4.50% C 3 5.11% D 4 5.86% E 5 6.25% The expected 2-year interest rate three years from now should be . Enter your answer in percent to the nearest hundredth, for example if your answer is .25432, enter 25.43.

7.98%

Explanation:

This deals with spot rates and forward rates. The 2 year interest rate three years from now is the 2 year forward rate, 3 years from now.

It can be calculated through the relationship below:

(1 + 5 year spot rate)⁵ = (1 + third year spot rate)³ * (1 + 2 year forward rate)²

(1 + 6.25%)⁵ = (1 + 5.11%)³ * (1 + 2 year forward rate)²

1.35408 = 1.161267 * (1 + 2 year forward rate)²

(1 + 2 year forward rate)² = 1.35408 / 1.161267

1 + 2 year forward rate = √1.16603675

2 year forward rate = √1.16603675 - 1

= 7.98%

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