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A 2 year bond, yield 6%. A 1 year bond, yield 4%. What's the implied rate for the bond that starts one year from now?

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(1+0.06)^2 = (1+0.04)*(1+x) Solve for x

The left hand side represents the gross return on a 2 year 6% bond

The right hand side represents two gross returns in sequence: first we hold a 1 year bond, then (for the next year) we hold a 1 year bond (that starts a year from now) with unknown return x

By expected interest parity (or by "the Expectations Hypothesis") the two sides have to be equal, there is no advantage (or disadvantage) to holding the 2 year bond or the two 1-year bonds in sequence.

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    $\begingroup$ You should explain the solution otherwise it only serves to answer the specific problem and provides no benefit to other readers. Not everyone who looks at it will go ahha it's interest rate parity. $\endgroup$ – AfterWorkGuinness Sep 24 '15 at 19:51

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