Homework Answers
a. The forward rate (f2) is the rate that makes the return from rolling over one-year bonds the same as the return from investing in the two-year maturity bond and holding to maturity:
=(1+8.2%)*(1+f2)=(1+9.2%)^2
=10.21%
b. According to the expectations hypothesis, the forward rate equals the expected value of the short-term interest rate next year so the best guess would be 10.21%
c. According to the liquidity preference hypothesis, the forward rate exceeds the expected short-term interest rate next year so the best guess would be lower than 10.21%
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