Suppose that a bond that will mature in two years has a face value of $1000 and 20% coupon rate. The one year spot market interest rate is 13% and the expected second period's forward rate is 12%. According to the expectation hypothesis, the two year spot rate is:

Question

Quizplus · Accepted Answer

According to the expectation hypothesis, the two-year spot rate is the average of the one-year and two-year forward rates.

The one-year forward rate is equal to the one-year spot rate of 13%.

The two-year forward rate can be calculated as follows:

(1 + 0.13)(1 + f) = (1 + 0.2)
1 + f = (1 + 0.2)/(1 + 0.13)
1 + f = 1.1249
f = 0.1249 or 12.49%

Therefore, the two-year spot rate is:

(0.13 + 0.1249)/2 = 0.12745 or 12.49%, which corresponds to choice C.

Suppose That a Bond That Will Mature in Two Years