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You observe that the current three-year discount factor for default-risk free cash flows is 0.68. Remember, the t-year discount factor is the present value of

You observe that the current three-year discount factor for default-risk free cash flows is 0.68. Remember, the t-year discount factor is the present value of $1 paid at time t, i.e. D=(1+r)^-t, where r(t) is the t-year spot interest rate (annual compounding). Assume all bonds have a face value of $100 and that all securities are default-risk free. All cash flows occur at the end of the year to which they relate.

d) Assuming annual compounding, determine the implied one-period forward rates f2 (i.e. between year 1 and 2) and f3 (i.e. between year 2 and 3) in this economy. What inference can you make about the markets estimate of the one-year spot interest rate at t = 1 if the liquidity preference theory is correct? (5 marks)

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