The yield to maturity on one-year zero-coupon bonds is 9%. The yield to maturity

Question

The yield to maturity on one-year zero-coupon bonds is 9%. The yield to maturity on two-year zero-coupon bonds is 10%. 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 %

Explanation / Answer

a. (1+ YTM2 ) ^2 = (1+ YTM1) (1+ Forward rate) ie (1+0.1)^2 = (1.1*1.1) = (1+0.09) (1+ forward rate) ie forward rate = 0.1101 = 11.01% b. short term rate = st. So for first year (1+ YTM1 ) = (1 + st1) ie st1 = 9% = YTM 1 and now let short term rate for next year = st2 then (1+YTM 2)^2 = (1+st1) + (1+st2) ie (1+ .10)^2 = (1+.09) (1+st2) ie st2 = 0.1101 = 11.01%

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