The Wall Street Journal Reports That The Rate On 6-Year Trea

The Wall Street Journalreports That The Rate On 6 Year Treasury Securi

The Wall Street Journal reports that the rate on 6-year Treasury securities is 1.95 percent and the rate on 8-year Treasury securities is 2.90 percent. According to the unbiased expectations hypothesis, what does the market expect the 2-year Treasury rate to be six years from today, E(6 r₂)? (Do not round intermediate calculations and round your answer to 2 decimal places.) please show the solution.

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The unbiased expectations hypothesis (UEH) suggests that the long-term interest rate is a geometric average of current and expected future short-term interest rates. This theory assumes that investors are indifferent between buying long-term securities and rolling over short-term securities because they expect the same return on both strategies, given rational expectations of future interest rates. This principle allows us to estimate future interest rates based on current long-term rates, which is essential in understanding market expectations and the forward-looking nature of interest rate movements.

Given the data from the Wall Street Journal indicating the current 6-year and 8-year Treasury security rates—specifically, 1.95% for the 6-year and 2.90% for the 8-year—the task is to determine the expected 2-year interest rate six years from now, E(6 r₂), according to the unbiased expectations hypothesis. The primary formula linking these interest rates is derived from the theory, which expresses a long-term rate as the average of current and expected future short-term rates:

(1 + R_n)^n = [(1 + r_1) (1 + r_2) ... * (1 + r_n)],

where R_n is the n-year interest rate, and r_i is the i-year interest rate for year i.

For our purposes, because compound interest is assumed and the interest rates are annual, the relationship simplifies into an arithmetic mean of the relevant forward rates when expressed in terms of the geometric average. Specifically, the 6-year rate (R_6) can be approximated as:

(1 + R_6)^6 ≈ (1 + r_1)(1 + r_2) ... (1 + r_6)

Similarly, the 8-year rate (R_8) relates to the 6-year rate and the 2-year rate starting in year 6 (E(6 r₂)) as:

(1 + R_8)^8 ≈ (1 + R_6)^6 * (1 + E(6 r₂))^2

Rearranged to solve for E(6 r₂), the expected 2-year rate in year six, the equation becomes:

(1 + E(6 r₂))^2 ≈ [(1 + R_8)^8] / [(1 + R_6)^6]

Using the supplied data: R_6 = 1.95% (or 0.0195), R_8 = 2.90% (or 0.0290), the calculation proceeds as follows:

First, compute (1 + R_6)^6:

(1 + 0.0195)^6 = 1.0195^6 ≈ 1.1228

Next, compute (1 + R_8)^8:

(1 + 0.0290)^8 = 1.0290^8 ≈ 1.2595

Then, find the ratio:

1.2595 / 1.1228 ≈ 1.1213

Now, take the square root to solve for the expected two-year rate starting in year six:

√1.1213 ≈ 1.0594

Subtract 1 to find the decimal rate:

1.0594 - 1 = 0.0594

Finally, convert to percentage and round to two decimal places:

0.0594 * 100 = 5.94%

Thus, based on the unbiased expectations hypothesis, the market expects the 2-year Treasury rate six years from now, E(6 r₂), to be approximately 5.94%.

References

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