Suppose we have the yield and maturity information on treasury securities from a current yield curve. A 1-year T-bond currently yields 4.50% and a 3-year T-bond yields 9.80%. Assuming the pure expectations theory is correct, what is the market's forecast for interest rates on a 2-year treasury security, 1 year from now

12.55%

Explanation:

The computation is shown below:

(1 + 3 Year Yield)^3 = (1 + 1 Year Yield) × (1 + 2 Year Yield 1 year from now)^2

(1 + 9.80%)^3 = (1 + 4.50%) × (1 + 2 Year Yield 1 year from now)^2

1.323753 = 1.0450 × (1 + 2 Year Yield 1 year from now)^2

1.266749 = (1 + 2 Year Yield 1 year from now)^2

1.1225 = 1 + 2 Year Yield 1 year from now

So,

2 Year Yield 1 year from now = 0.1255

= 12.55%