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Forward rates as estimates of arm index values

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Question: (Forward Rates as Estimates of ARM Index Values) An investor who is a strong believer in the expectations theory of interest rates is considering financing a property acquisition with an adjustable rate mortgage having annual interest adjustments indexed to the one-year Treasury. She obtains the following spot yields on zero coupon U.S. Treasury securities:

Maturity               Yield

1 year                 4.00%

2 year                 4.95%

3 year                 5.75%

4 tear                 6.33%

a. What are the ‘‘market's'' implied forecasts of the one-year Treasury yield (estimated ARM index value) in Years 2, 3, and 4?

b. Now assume that liquidity preference plays a role in explaining the upward shape of the yield curve. Do your answers in part (a) overstate or understate the ‘‘true'' estimated one year Treasury yields? Explain.

Reference no: EM131735531

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