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.

---

Definitions:

Residual Value

The estimated value that an asset will have at the end of its useful life.

Double-declining-balance

A method of accelerated depreciation calculating a larger depreciation charge in the first year of an asset's life and progressively smaller charges in subsequent years.

Depreciation Expense

The portion of the cost of a fixed asset that is charged as an expense in a particular accounting period, reflecting the asset's usage and wear and tear.

Betterments

Improvements made to a property or asset that increase its value or productivity.