Question

According to the liquidity premium theory, if the one-year interest rate over the next five years is expected to be 2%, 2.5%, 3.2%, 3.9%, and 4.2% per year respectively, and the liquidity premium for the same years are 0%, 0.5%, 1%, 1.5%, and 2%. What would be the interest rate on a four-year bond

Answer 1

Answer: 4.4%

Explanation;

Using the liquidity premium theory, the interest rate on the bond would be the average of one-year interest rates up to the year of interest plus the liquidity premium in the year of interest.

Interest on four-year bond = Average of one year rates up to Year 4 + Year 4 liquidity

= (( 2 + 2.5 + 3.2 + 3.9)/4) + 1.5

= 2.9 + 1.5

= 4.4%