The yield to maturity on one-year zero-coupon bonds is 8.5%. The yield to maturi

Question

The yield to maturity on one-year zero-coupon bonds is 8.5%. The yield to maturity on two-year zero-coupon bonds is 9.5%. 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)? O Lower O Higher

Explanation / Answer

forward rate for 2nd year=(1+rate for 2 years)^2/(1+rate for 1 year)-1=1.095^2/1.085-1=10.5092%

According to expectations hypothesis, forward rate for 2nd year equals expected value of short-term interest rate next year, best guess=10.5092%

According to liquidity preference hypothesis, forward rate exceeds expected short-term interest rate next year, best guess is less than 10.5092%.

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