Question

The yield to maturity on one-year zero-coupon bonds is 7.4%. The yield to maturity on two-year zero-coupon bonds is 8.4%.

a. What is the forward rate of interest for the second year? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Forward rate of interest             %

b. If you believe in the expectations hypothesis, what is your best guess as to the expected value of the short-term interest rate next year? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Short-term interest rate             %

c. If you believe in the liquidity preference theory, is your best guess as to next year’s short-term interest rate higher or lower than in (b)?

-	Lower
	-Higher

Answer 1

a) Forward rate is nothing but spot rate + earnings as return from investing in two year maturity bond and holding to maturity

Thus,

(1+7.4%) * (1+ forward rate) = (1+8.4%)^2

1.074*(1+ forward rate) = 1.084^2

1.074*(1+ forward rate) = 1.17056

(1+ forward rate) = 1.17056/1.074

(1+ forward rate) = 1.094093

Forward rate = 1.094093-1

=9.4093%

b) Expectation hypothesis is proposition that the long term rate is determined purely by current and future expected short term rate, in such a way that the final value from investing in long term bond equals to value investing in short term bonds, Thus short term rate would be 9.4093%

c) Liquidity preference theory suggest that the investor will demand higher interest rate for the bond offering more period of fund blocking. Thus as per this theory next years short term interest rate will be lower than in (b) as 2 year interest rate is 8.4%