"Definition: - Today’s long-term rate is the (arithmetic or geometric) average of the current short term rate and the successive forward or expected one period short-term rates during the period of long-term loan. - Example: Current one year bond rate: 7%, two expected or forward rate: 7.5% and 8.2% then term rate will be: [(1.07) (1.075) (1.082)]1/3 - 1=7.566% Assumptions: - Perfect competition in the financial market - Investors are rational: they want to maximize the yield of their holding period - Every investor has the uniform expectation about the future short-term interest rate - There is no transaction cost - Securities of different maturities are perfect substitutes Implications: - Long-term rate will be more than short-term rate if investors expect future short-term spot rates to be higher than the current short-term rate. - Long-term rate will be lower than short-term rate if investors expect future short-term spot rates to fall below the current short-term rate. - Long-term rate is equal to short-term rate if no change is expected between future short-term spot rates and current rate Drawbacks: - Faulty assumptions - Does not explain how the short-term rate is determined. Source: http://in.docsity.com/en-docs/Interest_Rate_-_Security_Analysis_and_Portfolio_Management_-_Solved_Quiz_"
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