The Wall Street Journal reports that the rate on three-year Treasury securities is 7.25 percent and the rate on four-year Treasury securities is 8.50 percent. The one-year interest rate expected in three years is E(₄r₁), 4.10 percent. According to the liquidity premium theory, what is the liquidity premium on the four-year Treasury security, L₄?

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that the interest rate on a long-term bond will equal the average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium. Using the given rates, the liquidity premium on the four-year Treasury security can be calculated as follows: 8.50% = (7.25% + 7.25% + 4.10% + E(4r1))/4 + L4. Solving for L4 gives approximately 8.2%.

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