Question: (Forward Rates as Estimates of ARM Index Values) An investor who is a strong believer in the expectations theory of interest rates is considering financing a property acquisition with an adjustable rate mortgage having annual interest adjustments indexed to the one-year Treasury. She obtains the following spot yields on zero coupon U.S. Treasury securities:
Maturity Yield
1 year 4.00%
2 year 4.95%
3 year 5.75%
4 tear 6.33%
a. What are the ‘‘market's'' implied forecasts of the one-year Treasury yield (estimated ARM index value) in Years 2, 3, and 4?
b. Now assume that liquidity preference plays a role in explaining the upward shape of the yield curve. Do your answers in part (a) overstate or understate the ‘‘true'' estimated one year Treasury yields? Explain.