The yield to maturity on one-year zero-coupon bonds is 7.8%. The yield to maturi

Question

The yield to maturity on one-year zero-coupon bonds is 7.8%. The yield to maturity on two-year zero-coupon bonds is 8.8%.

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)?

Higher

Lower

Explanation / Answer

a) Lets assume that forward interest rate for second year is x%, so

(1+7.8%) * (1+x%) = (1+8.8%)2

After solving above equation, we get x as 9.81%

b) According to expectations hypothesis, expected value of short term interest rates = forward rate

So the best guess for expected value of short term interest rates = 9.81%

c) According to liquidity preference theory, the forward rate exceeds the expected short term interest rate next year, so the best guess would be less than 9.81%

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