If a one-year bond currently yields 4% and is expected to yield 6% next year, the liquidity premium theory suggests the yield today on a two-year bond will be:
A) More than 4% but less than 5%.
B) 5%.
C) 4%.
D) More than 5%.

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, investors demand a higher yield to compensate for the risk of holding a longer-term bond. Since the yield on the one-year bond is expected to increase from 4% to 6% next year, investors would demand a higher yield on a two-year bond to compensate for the increased risk. Therefore, the yield on a two-year bond would be higher than the current 4% yield on a one-year bond, and given the expected increase, it would likely be higher than 5%. Therefore, the best choice is D - More than 5%.

If a One-Year Bond Currently Yields 4% and Is Expected