If a one-year bond currently yields 5% and is expected to yield 7% next year,the liquidity premium theory predicts that the yield today on a two-year bond should be
A) 5%.
B) less than 6%, but more than 5%.
C) 6%.
D) more than 6%.

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, the yield on a long-term bond is equal to the average of short-term interest rates expected to occur plus a premium for each year of additional maturity beyond the maturity of the short-term debt. In this case, the yield on a two-year bond would be equal to the yield on a one-year bond plus a liquidity premium for the additional year of maturity. Since the expected yield on a one-year bond is 5% and expected to increase to 7% next year, we can assume that the liquidity premium for the second year would be positive due to the expectation of rising interest rates. Therefore, the yield today on a two-year bond should be greater than 6% because it is the average of the 5% yield on the one-year bond and the liquidity premium for the second year.

If a One-Year Bond Currently Yields 5% and Is Expected