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Suppose that the 1-year interest rate is 5% (r01 = 0.05) and investors

expect that the future 1-year interest rate declines to 4% (E[r12] = 0.04). 1. What should be the price of a 2-year zero coupon bond with 100$ par value issued today, according to the expectations theory? 2. Would a price = 90 be consistent with the expectations theory? 3. Would a 1-year forward rate of 5% (f12 = 0.05) be consistent with the expectations theory? 4. If investors require a 2% premium to invest in the 2-year bond, what would be the price of the 2-year bond and the implied 2-year interest rate according to the liquidity preference theory? 1

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Subject: Business, Finance

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