Question

The Wall Street Journal reports that the rate on three-year Treasury securities is 1.22 percent and the rate on four-year Treasury securities is 1.4 percent. The one-year interest rate expected in three years, E(4r1), is 1.8 percent. According to the liquidity premium hypotheses, what is the liquidity premium on the four-year Treasury security, L4? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16))

Answer 1

0.142%

Step-by-step explanation:

We are required to find the liquidity premium on the four-year Treasury security (L4)

1R4 = 1.4%

1R3 = 1.22%

E(4r1) = 1.8%

1 + 1R4 = [{(1+1R3)^3} * (1+E(4R1) + L4)]^1/4

1 + 0.014 = [{(1 + 0.0122)^3) * (1+0.018 + L4)]^1/4

1.014^4 = [{(1 + 0.0122)^3) * (1+0.018 + L4)]

1.057187 = (1.0370483) * (1.018 + L4)

1.057187/1.0370483 = 1.018 + L4

1.0194192 = 1.018 + L4

L4 = 1.0194192 - 1.018

L4 = 0.00142

L4 = 0.142%

Hence, liquidity premium on the four-year Treasury security(L4) = 0.142%