Assume that the current yield on one-year securities is 6 percent, and that the yield on a two-year security is 7 percent. If the liquidity premium on a two-year security is 0.4 percent, then the one-year forward rate is
A)8.0 percent.
B)7.6 percent.
C)3.0 percent.
D)7.0 percent.

Question

Quizplus · Accepted Answer

The one-year forward rate can be calculated using the formula that equates the total return from investing in a two-year security to the total return from investing in two consecutive one-year securities (the first at the current yield and the second at the forward rate). Given a two-year yield of 7% and a liquidity premium of 0.4%, the expected return (pure expectation) for the two-year security is 7% - 0.4% = 6.6%. Let $f$ be the one-year forward rate for the second year. The equation is: $(1 + 0.06) \times (1 + f) = (1 + 0.066)^2$. Solving for $f$ gives approximately 7.6%.

Assume That the Current Yield on One-Year Securities Is 6