The current rate of return on a one-year U.S. Government security is 3

The current rate of return on a one-year U.S. Government security is 3%. The rate of return on a two-year U.S.
Government security is 5%. According to the expectations theory, what is the return on a one-year U.S.

Government security purchased one year from today?

ANSWER

$1,000 × 1.03 = $1,030 at the end of year one
$1,000 × (1.05)2 = $1,102.50 at the end of two years
$1,102.50 – $1,030 = $72.50 interest needed in year 2
$72.50/$1,030 = 7.04%