The yield to maturity on one-year zero-coupon bonds is 8.8%. The yield to maturi
ID: 2719648 • Letter: T
Question
The yield to maturity on one-year zero-coupon bonds is 8.8%. The yield to maturity on two-year zero-coupon bonds is 9.8%.
What is the forward rate of interest for the second year? (Do not round intermediate calculations.Round your answer to 2 decimal places.)
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.)
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)?
The yield to maturity on one-year zero-coupon bonds is 8.8%. The yield to maturity on two-year zero-coupon bonds is 9.8%.
Explanation / Answer
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 = (1+ Ytm 2 year)^2/(1+ 1year YTM) -1
Forward rate of interest = (1+9.8%)^2 /(1+8.8%) -1
Forward rate of interest = 10.81%
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.)
As per expectations hypothesis , best guess as to the expected value of the short-term interest rate next year would be forward rate of interest for the second year.
Short-term interest rate =Forward rate of Interest
Short-term interest rate = 10.81%
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)?
Answer
Lower
Note :
According to the liquidity preference theory, the forward rate exceeds the expected short- term interest rate next year, so the best guess would be lower than 10.81%
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