FIXED INCOME FUNDAMENTALS

fall 2018
Problem Set IX

I Assume semi-annual compounding (for this question).

The 1-year spot interest rate is 2%; the 1.5-year spot rate is 2.6%; the 2-yr is 3%.
What is the implied forward 6-month rate 18 months from today?
What is the implied forward 1-year rate 1 year from today?

II The 1-week money market rate is 5.9%; the four-week rate is 6%. What is the forward 1-week rate three
weeks from today?
What if the 1-week rate is also 6%?

III Given the following spot rates:

1-yr 2.5%
2-yr 3%
3-yr 3.5%
4-yr 3.75%

Suppose you believe that the 1-year implied forward for next year represents the market’s expected 1-
year rate for next year. However, you believe that 1-year forward rate (that you just calculated) is also
the rate the market expects for each of the years following that.
What are the liquidity premiums for each of the next three years?

IV The 25-year spot rate is 5%. The 30-year is 6%. Why is the implied 5-year forward rate 25 years from now
unrealistic as the market’s expectations for interest rates in 25 years?
What if the 30-year rate is 4.85% - same question?
How would liquidity premiums explain each of these situations?