Question

Assume that the current yield on one-year securities is 7 percent, and that the yield on a two-year security is 8 percent. If the liquidity premium on a two-year security is 0.6 percent, then the oneyear forward rate is approximately: a)8.4 percent. b) 8.6 percent. c) 7.6 percent. d)7.4 percent.

Answer 1

The one-year forward rate is approximately 7.6 percent.

Step-by-step explanation:

The one-year forward rate can be calculated using the formula:

Forward rate = Current yield + Liquidity premium

In this case, the current yield on one-year securities is 7 percent, and the liquidity premium on a two-year security is 0.6 percent. Thus, the one-year forward rate is approximately 7% + 0.6% = 7.6%. Therefore, the answer is c) 7.6 percent. The extra money known as the liquidity premium is intended to incentivize investments in assets that are difficult or time-consuming to turn into cash at fair market value.