Liquidity Premium Hypothesis Suppose we observe the following rates: ₁R₁ = 8%, ₁R₂ = 10%, and E(₂r₁) = 8%. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L₂?

Question

Quizplus · Accepted Answer

According to the liquidity premium hypothesis, the difference between the yield on a long-term and a short-term bond is equal to the expected average liquidity premium over the life of the long-term bond. Using the given data, we can calculate the liquidity premium for the second year: L₂ = (₂R - ₁R) - [E(₂R - ₁R)] L₂ = (10% - 8%) - [8% - 8%] L₂ = 2% Therefore, the liquidity premium for year 2 is 2%, which is equivalent to 4.04% on an annual basis [(1.02)^2 - 1]. The best choice is B.

Liquidity Premium Hypothesis Suppose We Observe the Following Rates: 1R1

Liquidity Premium Hypothesis Suppose We Observe the Following Rates: ₁R₁