Introduction to Finance

expectations theory 
states that the 
shape of the yield curve indicates 
investor expectations about future 
infl ation rates

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206
C H A PT E R 8 Interest Rates
Let’s assume that the current rates of interest or yields are, as follows: one-year Treasury 
bills = 3 percent, two-year Treasury notes = 4 percent, and 10-year Treasury notes = 5 percent. 
Using a 1 percent real rate of return, we have the following relationships:
Maturity
r
=
RR
+
IP
1-year
3%
=
1%
+
2%
2-year
4%
=
1%
+
3%
10-year
5%
=
1%
+
4%
Thus, the infl ation rate is expected to be 2 percent over the next year. However, the infl ation 
rate is expected to average 3 percent per year over the next two years; or if infl ation is 2 percent 
the fi rst year, then the rate for the second year must be more than 3 percent. Working with simple 
averages, 3 percent average infl ation times two years means that the total infl ation will be 6 
percent. Thus, 6 percent less 2 percent means that infl ation in the second year must be 4 percent.
For years three through 10, infl ation must exceed 4 percent annually to average 4 percent 
over the 10-year period. We can fi nd the simple average by starting with the fact that infl ation 
will be 40 percent (4 percent times 10 years) over the full 10-year period, and 40 percent less 
the 6 percent for the fi rst two years means that cumulative infl ation for the last eight years will 
be 34 percent. Then, dividing 34 percent by eight means that infl ation will have to average 
4.25 percent over years three through 10. In summary, we have the following:
Time Period
Average