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FRM Part I · FRM Exam Part I · Properties of Interest Rates

A two-year spot rate is 4.00% and the one-year spot rate is 3.00% (annual compounding). Survey evidence suggests the market's expected one-year rate in one year is 4.60%. Based on liquidity preference theory, which conclusion is most consistent with this data?

The forward rate implied by the spot curve is about 5.01%, while the expected rate is 4.60%. Liquidity preference theory says forwards exceed expected rates by a premium, so the premium is roughly 0.41%. Pure expectations would require equality, which fails here.

  1. AThe implied forward rate of about 5.01% includes a liquidity premium of about 0.41% over the expected rateCorrect
  2. BThe forward rate is below the expected rate, implying a negative liquidity premium
  3. CThe forward rate equals the expected rate, so pure expectations holds
  4. DThe data imply the curve is inverted

Explanation

Forward = 1.0816/1.03 − 1 = 5.01%. Liquidity preference theory says forward = expected rate + liquidity premium, so premium ≈ 5.01% − 4.60% = 0.41%. A negative premium or equality contradicts the numbers, and the curve is upward sloping (3% to 4%), not inverted.

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