The yield to maturity on one-year zero-coupon bonds is 8.4%. The yield to maturi

Question

The yield to maturity on one-year zero-coupon bonds is 8.4%. The yield to maturity on two-year zero-coupon bonds is 9.4%.

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) Using expectation theory,

(1 + S2)^2 = (1 + S1) x (1 + F1)

where S2 - Current 2-year rate = 9.4%, S1 - Current 1-year rate = 8.4%, F1 - Forward rate

=> (1 + 9.4%)^2 = (1 + 8.4%) x (1 + F1)

=> F1 = 10.41%

b) Hence, one year rate one year later = 10.41%

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