Consider the Following Spot Rates: I₀₁ = 6%,i₀₂ = 7%,i₀₃

question 17

Essay

Consider the following spot rates: i₀₁ = 6%,i₀₂ = 7%,i₀₃ = 7.5%,i₀₄ = 8%,i₀₅ = 9%.
a. Based on the pure expectations theory, what does the market expect the one-year spot rate to be at the end of year 3?
b. Based on the liquidity premium hypothesis, would you expect the actual one-year spot rate at the end of year 3 to be below the number you computed in part a? Why or why not?
c. Based on the pure expectations hypothesis, what does the market expect the two-year (annualized) spot rate to be at the end of year 3?
d. Can we say whether the yield to maturity on a four-year coupon bond will be above or below 8%? Explain.

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Definitions:

Consolidation Adjustment

Adjustments made to a parent company's financial statements to remove the effects of intercompany transactions when consolidating its subsidiaries' financial statements.

Depreciation Expense

The allocated portion of the cost of a tangible fixed asset that is charged as an expense in a reporting period, reflecting the usage and wear and tear of the asset.

Accumulated Depreciation

The total amount of a tangible asset's cost that has been expensed to depreciation over the asset's useful life, reflecting how much of the asset's value has been used up.

Consolidation Worksheet

A tool used in preparing consolidated financial statements, allowing a company to adjust and eliminate the transactions among its controlled entities.