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, the yield on a longer-term bond includes a premium to compensate investors for the greater risk and uncertainty of tying up their funds for a longer period of time.

In this scenario, investors would expect to be compensated with a higher yield on the two-year bond than the current 4% yield on the one-year bond, to account for the added risk and uncertainty of holding the bond for an additional year.

Since the expected yield on the one-year bond next year is 6%, it is reasonable to assume that the yield on the two-year bond would be higher than that, given the added uncertainty of the second year's yield.

Therefore, the yield today on a two-year bond is likely to be more than 5%, making answer choice D the best option.

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