If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one-year loan is 7% and a two-year loan is 8%,it should quote 7.5%,which is the average of the two rates.

Question

Quizplus · Accepted Answer

The bank should actually quote a rate higher than 7.5% because there is a higher risk associated with providing a loan one year from now, as opposed to providing a loan immediately. This is known as the term premium or liquidity premium. Therefore, the correct answer is B, as it is incorrect to quote a rate that is simply the average of the two existing rates.

If a Bank Is Asked to Quote a Rate on a One-Year