Question

1. Explain the factors that determine the risk structure of interest rates. Explain how a change of each factor changes interest rates. [5 marks]

2. Suppose the liquidity premium is 0.4%, and the one-year Canada bond rate is 8% and two-year Canada bond rate is 10%. Please calculate the forward rate i^e_t+1. [5 marks] (Hint: Using the method showed in Application-Forward Rate in the textbook)

Answer 1

And 1 Factors that determine the risk structure of interest rates are :

A) Supply Demand relation : As supply of short term bonds falls, short term rates falls and as supply of long term bonds rises , long term interest rates rises. Thus this gives a inclined interest rate profile.

B) Risk preference: As long term bond takes a lot of time to mature, so high risks are associated with that like credit risk and market risk of defaulting . Thus high liquidating premium is asked . This results in an inclined interest rate profile.

C) Expectation theory : So if investors are expecting long term interest rates to rise, thus this creates an inclined interest rate profile with long term interest rates higher than short term interest rates.

And 2 = (1+ R2)^2 = (1+R1)*(1+Rt)

(1.1)^2 = 1.08*(1+Rt)

Rt = 12.04%

Thus forward rate i.e. t+1 is 12.04%