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The yield to maturity on one-year zero-coupon bonds is 8%, the yield to maturity on two-year zero-coupon bonds is 10%.
a. What is the forward rate of interest for the second year?
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?
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)?
Note: the yield to maturity of a zero coupon bond is equal to the r0t implied by that bond.
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