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Answer: More than 3.5%
Under liquidity preference theory, investors prefer short maturities and require a positive liquidity premium to hold longer maturities. As a result, the long-term spot rate is generally **higher** than the average of expected future short rates. Here, the expectations-theory benchmark is 3.5%, so the two-year zero rate must be **more than 3.5%**. **Correct answer: C. More than 3.5%**
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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