The yield on a one-year bond is currently 4% and the expected yield on one-year bonds for the next two years is 5% and 6%. If the liquidity premium is 0.5%, what is the yield on a bond with two years to maturity?
A) 4.5%
B) 5%
C) 5.5%
D) 6%

Question

Quizplus · Accepted Answer

The yield on a two-year bond can be calculated using the liquidity premium theory, which suggests that the yield on a bond is equal to the average of the expected future short-term interest rates over the bond's maturity plus a liquidity premium. In this case, the average of the expected yields (5% and 6%) is 5.5%. Adding the liquidity premium of 0.5% to this average gives a total yield of 6%. However, the correct calculation for the yield on a two-year bond should consider the current yield and the expected future yields without directly adding the liquidity premium to the average expected yield. The correct approach involves finding the yield that equalizes the present value of the bond's payments to its price, considering the liquidity premium as part of the bond's overall yield environment. The mistake in the explanation led to an incorrect conclusion. The correct yield, considering the liquidity premium and the expected future yields, would actually average out without directly adding the liquidity premium to the expected yields, leading to a different calculation method typically involving more complex financial formulas not fully detailed here. The correct answer, based on the information provided and the typical approach to such a question, would be to look for an average that incorporates the liquidity premium in a way that affects the overall yield environment, not by simply adding it to the average of expected yields.

The Yield on a One-Year Bond Is Currently 4% and the Expected