Question

For yearly spot rates (10%, 9%, 8%, 7%), we assume that the interest rates evolve according to expectations dynamics. a) Find the forecasts of future spot rates after one year and after two years. b) Do the investors in the market believe (expect) that interest rates will increase in the future?

Answer 1

The yearly spot rates are given as

10% , 9% , 8%, 7%. This shows the evolution of interest rates which means it is falling by 1% every year. From this we can map the future interest rates because it is based on expectations dynamics meaning people's expectations are based on past experiences.

a)Forecasts of future spot rates after one year = 6% (Since last was 7% and every year interest rates drop by 1%)

Forecast after 2 years = 5%( 7% then 6% then 5%)

b) No, the investors in the market do not believe that interest rates will increase in future. Rather they believe rhat future interest rates will decline. This is so because the evolution is Based on expectations , which is further based on past experiences , meaning they will expect the interest rates to fall due to past experiences