Assume that interest rates on one-year bonds for the next six years are expected
ID: 2816085 • Letter: A
Question
Assume that interest rates on one-year bonds for the next six years are expected to be 3%, 3.5%, 4.5%,
5.5%. 6.25%, and 7.75%. Assume, furthermore, that the liquidity premium for investors to hold bonds with maturities longer than one year are 0.4% for the 2-year bond, and 0.8%, 1.2%, 1.4%, and 1.8%, respectively, for bonds with maturities ranging from 3 to 6 years.
What is the interest rate on a 4-year bond, according to the Expectations Theory? Please show your work.
What is the interest rate on a 5 year bond, according to the Liquidity Premium Theory?Please show your work.
Explanation / Answer
Expectations theory: (3%+3.5%+4.5%+5.5%)/4=4.125%
Liquidity Premium theory: (3%+3.5%+4.5%+5.5%)/4+1.2%=5.225%