Suppose we observe the following rates: ₁R₁ = 13%, ₁R₂ = 16%, and E(₂r₁) = 10%. 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 theory, the yield on a longer-term bond is equal to the yield on a shorter-term bond plus a liquidity premium. Therefore, we can use the following equation: ₂ = ₁ + LP LP = ₂ - ₁ Using the observed rates, we get: LP = 16% - 13% = 3% LP = 0.1 - 0.13*0.11/0.87 = 0.091 = 9.1% Therefore, the liquidity premium for year 2 is 9.1%. The answer is B.

Suppose We Observe the Following Rates: 1R1 = 13%, 1R2

Suppose We Observe the Following Rates: ₁R₁ = 13%, ₁R₂