According to the expectations hypothesis (EH), long-maturity yields reflect expectations about future short-maturity yields. Suppose the EH is false. Specifically, suppose that (1+Y(2))^2 > (1+Y(1))*(1+E[Y(1)]), where the expectation is for next year's one-year rate. What can you conclude?a. Investors are not risk-neutral or some other assumption behind the EH does not hold. b. There is an arbitrage opportunity of buying the two year-bond (lending for two years), while also selling the one-year bond today and selling next year’s one-year bond next year (borrowing today for one year and repaying in ayear by borrowing for another year).c. There is an arbitrage opportunity of selling the two year-bond (borrowing for two years), while also buying theone-year bond today and buying next year’s one-year bond next year (lending today for a year and lending again ina year for one more year).d. All of the above.

Complete Questions: In order

According to the expectations hypothesis (EH), long-maturity yields reflect expectations about future short-maturity yields. Suppose the EH is false. Specifically, suppose that (1+Y(2))^2 > (1+Y(1))*(1+E[Y(1)]), where the expectation is for next year's one-year rate. What can you conclude?

a. Investors are not risk-neutral or some other assumption behind the EH does not hold.

b. There is an arbitrage opportunity of buying the two year-bond (lending for two years), while also selling the one-year bond today and selling next year’s one-year bond next year (borrowing today for one year and repaying in a year by borrowing for another year).

c. There is an arbitrage opportunity of selling the two year-bond (borrowing for two years), while also buying theone-year bond today and buying next year’s one-year bond next year (lending today for a year and lending again ina year for one more year).

d. All of the above.

option b

Explanation:

According to the expectations hypothesis theory, long maturity yields reflect future short maturity yields. If it does not hold such that the two year rate compounded for two years is greater than product of spot rates for two years, this means that there is an arbitrage opportunity. According to the equation given, option B is correct. That is, if we lend for two years, and sell the lesser return bond of one year today and then next year bond is sold for one year, then the lending rate for 2 year would give a higher return.

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explanation:

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