The forward rate of interest for the second year is 9.41%. According to expectations hypothesis, the expected value of the short- term value of the short term interest rate next year would be 9.41%. The next year's short-term interest rate will be lower.
The explanations and computations are as under:
a. 9.41%
b. According to expectations hypothesis the expected value of the short- term value of the short term interest rate next year would be 9.41% since the forward rate exceeds the expected value of the short - term interest rate next year
c. Lower
According to the liquidity preference hypothesis, since the forward rate exceeds short- term interest rate next year, so the best guess would be less than 9.41%
Working note
The forward rate (f2) is the spot rate plus earnings as the return from investing in the two - year maturity bond and holding to maturity
<u>(1 + 7.4%) x (1 + forward rate ) = (1 + 8.4%)^2</u>
Solving equation
1.074 x (1 + f2) = 1.175056
f2 = (1.175056 - 1.074) / 1.074
f2 = 9.41%
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