Chapter 15, Problem 1PS

Summary Introduction

To determine: The relationship between the forward rates and the future short rates expected by the market is to be identified and explained in terms of Expectations Theory and Liquidity Preference Theory.

Introduction: Using Expectations Theory, one can try to predict the short-term interest rates will be based on the existing long-term rates.

Liquidity Preference Theory suggests the investors to demand higher interest rates or premium rates for holdings with long-term maturities and higher risk.

Answer to Problem 1PS

Supported by the statement of expectations theory, it can be concluded that the bonds having different maturity will have different yields. Based on the Theory of Liquidity Preference, it is suggested that investors should prefer to lend in short periods, and the borrowers should prefer to borrow for longer periods.

Explanation of Solution

Given Information:

Contrast and explain the relation between the forward rates and market’s expected future short rates, in the context of Expectations Theory and Liquidity Preference Theory.

Based on the Expectations Theory, the average of short terms that are expected to prevail equals to the long term interest rates. Forward rates are those that derive from linking the current spot interest rate of a longer holding period with the current spot interest rate of a shorter holding period. Hence, it can be concluded that the yield curve with no risk premium involved provides market expectations of the future short rates.