7. Forward Rate

a. Determine the forward rate for various one-year

interest rate scenarios if the two-year interest rate is 8 percent, assuming no liquidity premium, Explain

the relationship between the one-year interest rate and

the one-year forward rate while holding the two-year

interest rate constant.

b. Determine the one-year forward rate for the same

one-year interest rate scenarios described in question

(a) while assuming a liquidity premium of 0.4 percent.

Does the relationship between the one-year interest

rate and the forward rate change when the liquidity

premium is considered?

c. Determine how the one-year forward rate would

be affected if the quoted two-year interest rate rises,

while both the quoted one-year interest rate and the

liquidity premium are held constant. Explain the logic

of this relationship.

d. Determine how the one-year forward rate would

be affected if the liquidity premium rises and if the

quoted one-year interest rate is held constant. What

if the quoted two-year interest rate is held constant?

Explain the logic of this relationship.