The Wall Street Journal reports that the rate on 3-year Treasury securities is 7.25% and the rate on 4-year Treasury securities is 8.50%. The one-year interest rate expected in three years is E(₄r₁), 4.10%. 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 yield curve can be decomposed into an expected future short-term interest rate and a liquidity premium.

Using the formula: 
4-year Treasury yield = 3-year Treasury yield + liquidity premium + expected one-year interest rate in year 4

8.50% = 7.25% + liquidity premium + 4.10%

Solving for the liquidity premium, we get:

liquidity premium = 8.50% - 7.25% - 4.10%
liquidity premium = 1.15%

Therefore, the liquidity premium on the 4-year Treasury security is 1.15%, which is equivalent to 8.2% of the 3-year Treasury yield (7.25% * 0.082 = 0.5955%).

The closest answer choice is C) 8.2%.

The Wall Street Journal Reports That the Rate on 3-Year