Question

According to the liquidity premium theory, if the yield on both one- and two-year bonds are the same, would you expect the one-year yield in one-year's time to be higher, lower, or the same?

Answer 1

One-year yield in one-year's time to be lower.

Step-by-step explanation:

As per liquidity premium theory, two years yield is the average of current year and next year yield of one-year which is divided by 2 and risk premium is added to adjust the Interest and inflation rate risk faced by the longer maturity.

i2,t = rp + (i1,t + ie 1, t +1)/

From the above formula, if one-and two-year yields are the same and the risk premium is included in the two-year yield, so one-year yield in next year must be lower than current year’s.