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The 4-year T-bond rate is 6.05%. It is expected that the 2-year rate after 2 years from today is 4.85%. Under the pure expectation theory, what is the equilibrium rate of return on a 2-year T-bond?
Using pure expectation theory, (1 + 4-year T-bond)^4 = (1 + 2-year Rate)^2 (1 + 2-year rate)^2 (1 + 0.0605)^4 = (1 + 0.0485)^2 (1 + R)^2 (1.0605)^4/(1.0485)^2 = (1 + R)^2 1.150551 =…

(1 + R)^2 1 + R = (1.150551)^(1/2) 1 + R = 1.0726 R = 7.26% The equilibrium rate of return on a 2 year T-bond is 7.26%.

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