Suppose a current 6-year bond has a 6% rate and a 3-year bond has a 3% rate, and the liquidity premium (LP) for the 6-year bond is 0.20% and the LP for the 3-year bond is 0.10%, what is the expected (forward) rate for a 3-year bond issued 3 years from now under the Liquidity Premium Theory?

Question

Quizplus · Accepted Answer

1st deduct the LP from each bond, so: 
Adjusted 6-year bond rate = 6% - 0.20% = 5.80% 
Adjusted 3-year bond rate = 3% - 0.10% = 2.90% 
Expected 3-year rate 3 years from now = [(1.058)^6/(1.029)^3]^1/3 - 1 
= [1.4025/.0896]^.333 - 1 = .0877 or 8.77% 
Add back the liquidity Premium of .10%: Expected 3 yr. rate = 8.87%

Suppose a Current 6-Year Bond Has a 6% Rate and a 3-Year