Question

2.

a)If the rate for a 2-year maturity is 2.90% and the rate for a 3-year maturity is 3%, what is the implied one year rate two years from now?

b) Under the two theories of the yield curve, what is your interpretation of the result in this problem?

Answer 1

(a) Let the implied one-year rate two years from now be r. Then,

((1 + 0.029)^2) * (1 + r) = (1 + 0.03)^3

(1 + r) = 1.032003

r = 0.032003, or 3.2%

(b)

Under the expectations theory, a higher rate for longer maturities (positive yield curve) is due to expectations of rising short-term interest rates. In this problem we can see that the yield curve is positive. That means the market is expecting short-term interest rates to rise

Under the liquidty preference theory, investors prefer liquidity to returns. Short-term securities that are more liquid would have lower rates and longer term securities would have higher rates. In this problem, this theory seems to hold as the short-term rates are lower than longer term rates