The yield to maturity on one-year zero-coupon bonds is 7.3%. The yield to maturi

Question

The yield to maturity on one-year zero-coupon bonds is 7.3%. The yield to maturity on two-year zero-coupon bonds is 8.3%. 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)?

Explanation / Answer

a Assume the forward rate for year 2 = i YTM 2 year maturity bond 8.30% YTM 1 year maturity bond 7.30% So , 1.083^2 =(1.073)^*(1+i) [equivalent yield in 2years] 1.173=1.073+1.073i                        1.173 i=0.100/1.073 or i=9.3% So ,forward rate for second year =9.3% b If Rtl is the two year long term interest rate Rst = One year interest rate Rst1 = short term interest rate next year then as per expectation hypothesis (1+Rtl)^2=(1+Rst)*(1+Rst1) or 1.083^2=1.073*(1+Rst1) Or Rst1=9.3% So short term interest rate next year is 9.30% c As per liquidity preference thoeory , higher the liquidity prefernce, higher is the interest rate. As the interest rate is showing an increasing trend and no information regarding supply of money given we can assume that the short term interest rate will be higher than 9.3% next year.

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