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Answer: It is possible for the market consensus to forecast a future one-year (nominal) zero rate of 2.5%; i.e., a decrease in the future expected spot rate
Under **liquidity preference theory**, the forward rate equals the expected future short rate **plus a positive risk premium**. Therefore, an upward-sloping term structure does **not** imply that expected future short rates must rise; the risk premium may be driving the slope. So it is entirely possible for the market consensus to forecast a future one-year nominal zero rate of **2.5%** even though the observed rates are 3.0%, 3.5%, and 4.0%, provided that the liquidity premium is sufficiently large to make the forward/term rates higher. Thus: - **A** is not necessarily true. - **B** is not necessarily true. - **C** is not necessarily true. - **D** is the only statement that must be considered possible under liquidity preference theory.
Author: Manit Arora
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Question 162.5. Assume we observe the following zero (spot) rate curve: one-year zero at 3.0%, two-year zero at 3.5%, three-year zero at 4.0%. Under the LIQUIDITY PREFERENCE THEORY, which of the following is necessarily TRUE?
A
The expected future one-year zero rate in one year is 4.0%
B
If the rates are nominal, and if the real rate plus inflation rate equals the nominal rate, the consensus is forecasting an increase in the one-year inflation rate
C
The market is forecasting an increase in the future one-year (nominal) zero rates
D
It is possible for the market consensus to forecast a future one-year (nominal) zero rate of 2.5%; i.e., a decrease in the future expected spot rate
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