Chapter 10, Problem 41PS

Summary Introduction

(a)

To calculate:

The forward rate of interest for the second year

Introduction:

The forward rate of interest is the rate which is a short-term interest rate for the future period used for making the return of short-term bonds same as equal to the total expected return of long-term bonds with a condition to holding them till maturity.

Summary Introduction

(b)

To calculate:

Expected value of short-term interest rate under expectations hypothesis.

Introduction:

The expectations hypothesis is a theory that says that yield to maturity is determined solely by expectations of future short-term interest rates. In this way, it provides a way to equalize expected yield from the investment in short-term bonds and long-term bonds.

Summary Introduction

(c)

To calculate:

Expected value of short-term interest rate under liquidity preference theory.

Introduction:

The liquidity preference theory is a theory which says that investors demand a risk premium on long-term maturity bonds as they involve high risk. The liquidity premium can be measured as a spread between the expected short rate and the forward rate of interest.