One-year Treasury bills currently earn 2.95 percent. You expected that one year from now, one-year Treasury bill rates will increase to 3.15 percent and that two years from now, one-year Treasury bill rates will increase to 3.35 percent. The liquidity premium on two-year securities is 0.05 percent and on three-year securities is 0.15 percent. If the liquidity theory is correct, what should the current rate be on three-year Treasury securities?

Question

Quizplus · Accepted Answer

According to the liquidity theory, the interest rate on a long-term security is the average of expected short-term rates over the life of the security plus a liquidity premium for each year. 
Therefore, the expected rate for three-year Treasury securities is calculated as follows:

Expected rate = [(2.95% + 3.15% + 3.35%) / 3] + (0.05% + 0.15%) 
Expected rate = 3.15% + 0.20% 
Expected rate = 3.35%

Therefore, the current rate on three-year Treasury securities should be 3.35 percent. The closest answer choice is C (3.22 percent), but this is not the correct answer as it is lower than the expected rate.

One-Year Treasury Bills Currently Earn 2