Liquidity Premium Hypothesis The Wall Street Journal reports that the rate on 3-year Treasury securities is 4.75 percent and the rate on 4-year Treasury securities is 5.00 percent. The one-year interest rate expected in three years is E(₄r₁), 5.25 percent. According to the liquidity premium hypotheses, what is the liquidity premium on the 4-year Treasury security, L₄?

Question

Quizplus · Accepted Answer

According to the liquidity premium hypotheses, the difference in yield between two comparable maturity bonds is equal to the expected average of the short-term interest rates over the time that the longer maturity bond has until it matures. In this case, the difference in yield between the 3-year Treasury security (4.75%) and the 4-year Treasury security (5.00%) is 0.25%. The one-year interest rate expected in three years is 5.25%. Therefore, the liquidity premium on the 4-year Treasury security is: L₄ = E(₄r₁) - (5.00% - 4.75%) = 5.25% - 0.25% = 5.00%. So, the correct answer is B, 0.504%.

Liquidity Premium Hypothesis the Wall Street Journal Reports That the Rate