One-year Treasury bills currently earn 5.50 percent. You expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent. The liquidity premium on two-year securities is 0.075 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities?

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, the rate on a two-year security should be the average of the current one-year rate and the expected one-year rate in the future, plus the liquidity premium. Thus, (5.50% + 5.75%) / 2 + 0.075% = 5.6625%, which rounds to 5.662%.

One-Year Treasury Bills Currently Earn 5