One-year Treasury bills currently earn 2.95 percent. You expect that one year from now, one-year Treasury bill rates will increase to 3.15 percent and that two years from now, one-year Treasury bill rates will increase to 3.35 percent. The liquidity premium on two-year securities is 0.05 percent and on three-year securities is 0.15 percent. If the liquidity theory is correct, what should the current rate be on three-year Treasury securities?

Question

Quizplus · Accepted Answer

The liquidity theory suggests that long-term interest rates are an average of current and expected short-term interest rates, adjusted for a liquidity premium. To find the current rate on three-year Treasury securities, we average the current one-year rate (2.95%), the expected one-year rate one year from now (3.15%), and the expected one-year rate two years from now (3.35%), then add the liquidity premium for three-year securities (0.15%). The calculation is as follows: [(2.95% + 3.15% + 3.35%) / 3] + 0.15% = 3.07% + 0.15% = 3.22%.

One-Year Treasury Bills Currently Earn 2