These are true or false questions, and please give explanations: 1. If the forward rate between...

These are true or false questions, and please give explanations:

1. If the forward rate between two periods exceeds the expected short rate between them, there is an arbitrage opportunity.

2. Given the liquidity preference hypothesis, investing a longer maturity bond is expected to return more than investing in short maturity bonds and "rolling them over" when they mature.

Solutions

Expert Solution

1.) This statement is true.

This is because the forward rate is calculated by the expected short-term rate between the time of entering the forward and the time of the expiration of the forward. If the short term rate is higher than the forward-rate, an arbitrageur will sell the forward and buy the spot, thus encashing the interest rate differential between the forward rate and the short-term rate.

2) This statement is true.

According to the liquidity preference hypothesis, longer-term maturity bonds pay the investor a higher return as long-term maturities have higher risks. This is due to the fact that short-term maturity bonds have higher liquidity, ie. investor can liquidate the bond in a short time that in longer-term maturity bonds. Also, this higher liquidity gives the investor an opportunity to speculate on the interest rate. If the interest rate increase, the investor can re-invest in higher interest rate bonds.

Hence, due to the lower liquidity (and hence lower speculative power) and higher risks in the longer-term bonds, they must compensate investors with higher returns than short-maturity bonds.

jeff jeffy answered 1 year ago

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