Answer-first summary for fast verification
Answer: More than 3.5%
Under liquidity preference theory, investors require a positive liquidity premium for holding longer-maturity bonds. As a result, longer-term spot rates are typically **higher** than the pure expectations-theory average. From Question 162.1, the expectations-theory value would be 3.5%. Liquidity preference theory implies the two-year zero rate should be **greater than 3.5%**. So the correct answer is **C**.
Author: Manit Arora
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Question 162.3. Given the same information, and market expects the one-year zero rate to increase to 4.0% in one year (continuous compounding), under the LIQUIDITY PREFERENCE THEORY of interest rate term structure, what is the current two-year zero rate, ?
A
Less than 3.5%
B
3.5%
C
More than 3.5%
D
Unclear from information given
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