One-year Treasury bills currently earn 4.5 percent. You expect that one year from now, one-year Treasury bill rates will increase to 6.65 percent. The liquidity premium on two-year securities is 0.05 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities?

Question

Quizplus · Accepted Answer

According to the liquidity theory, the interest rates on longer-term securities include a liquidity premium, which reflects the added risk of holding a security that cannot be easily sold in the secondary market. Therefore, the rate on a 2-year Treasury security should be equal to the average of the expected 1-year rates over the next two years plus the liquidity premium.
Expected 1-year rate one year from now = 6.65%
Expected 1-year rate today = 4.5%
Average expected 1-year rate over the next two years = (6.65% + 4.5%)/2 = 5.575%
Adding a liquidity premium of 0.05%, the current rate on a 2-year Treasury security should be 5.575% + 0.05% = 5.59%. Therefore, the correct choice is B.

One-Year Treasury Bills Currently Earn 4