Question

One-year Treasury bills currently earn 4.20 percent. You expect that one year from now, 1-year Treasury bill rates will increase to 4.40 percent. The liquidity premium on 2-year securities is 0.10 percent. If the liquidity premium theory is correct, what should the current rate be on 2-year Treasury securities?

Answer 1

So, according to the liquidity premium theory, the current rate on 2-year Treasury securities should be 4.40%.

Explanation:

According to the liquidity premium theory, the interest rate on a long-term bond is the average of the short-term interest rate expectations over the life of the bond plus a liquidity premium. In this case, we want to find the current rate on 2-year Treasury securities.

Let:

r_1 = current 1-year Treasury bill rate = 4.20%

r_2 = expected 1-year Treasury bill rate one year from now = 4.40%

LP_2 = liquidity premium on 2-year securities = 0.10%

Using the liquidity premium theory, the current rate on 2-year Treasury securities (r_2-year) can be calculated as follows:

r_2-year = (r_1 + r_2 + LP_2) / 2

r_2-year = (4.20% + 4.40% + 0.10%) / 2

r_2-year = (8.70% + 0.10%) / 2

r_2-year = 8.80% / 2

r_2-year = 4.40%

So, according to the liquidity premium theory, the current rate on 2-year Treasury securities should be 4.40%.