Question

The yield to maturity on one-year zero-coupon bonds is 7.1%. The yield to maturity on two-year zero-coupon bonds is 8.1%. a. What is the forward rate of interest for the second year? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Answer is complete and correct. Forward rate of interest 9.10 % 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.) Answer is complete but not entirely correct. Short-term interest rate 12.34 % 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

Answer 1

a) The first part is correctly answered by you.

Forward interest rate for 2nd year can be calculated as = (1+2 year Zero coupon rate)² / (1+ 1 year Zero coupon rate)   - 1

= 1.081²/1.071 - 1

= 0.09109 = 9.11%

b) The Expectation hypothesis states that the different period bonds can be viewed as a series of One period bonds with yield of each period bond equal to the expected short term interest rate

So , the expected short term interest rate next year should be equal to the forward rate next year i.e. 9.11%

c) Again, this part is correctly answered by you. Reason is that since investors give a preference to liquidity , the yield from a two year bond should be higher than the combined yield of two one year bonds, one maturing one year from now and another maturing two year from now , because investors will value two one year bonds higher because of increased liquidity. Hence the expected short term interest rate will be lower if we follow liquidity preference theory.