B. Ali believes that with expectations for inflation over the next year, investors require 8% for a one-year loan. Suppose investors currently expect inflation for the next year (the second year) to be higher so that they expect to require 10% for a one-year loan (starting one year from now). 5. Then, using the Pure-Expectations Hypothesis, which is consistent with the current 2-year spot rate, find r2. 6. Use the same data of part B, by using the Liquidity-Preference Hypothesis, find r2, given that the liquidity premium is 2%.
The pure expectation hypothesis:
The pure expectations hypothesis states that the return earned on a security with a two year maturity must be the same as investing in a one year secturity, and then reinvesting the amount at the end of a year for another year.
The interest rates on the one and two year securities are kown as the spot rates.
The one year interest rate prevailing in the interim in known as the one-year forward rate.
The Liquidity Premium Theory:
The liquidity premium theory states that investors inherently prefer liquid assets, and hence do not mind accepting a lower interest rate for short-term securities. It also states that the longer the investment period, the greater will be the premium demanded to compensate for the lower liquidity.
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