Assuming that the liquidity premium theory is? correct, on March? 5, 2010, what
ID: 2825875 • Letter: A
Question
Assuming that the liquidity premium theory is? correct, on March? 5, 2010, what did investors expect the interest rate to be on the? one-year Treasury bill two years from that date if the term premium on a? two-year Treasury note was 0.02?% and the term premium on a? three-year Treasury note was 0.03?%?
The correct answer is 2.96 according to MyLabsPlus, but I don't see how they are getting to that answer. Can someone please show me step by step how to get this correct answer?
Date Yr 1 Yr 2 Yr 3 3/5/2010 0.37% .88% 1.59%Explanation / Answer
(0 * 3)3 = (0 *1) (1*2) (2*3)
i.e. the amount invested now for 3years(0-3) spot rate and interest received after 3years should be equal to amount invested now for 1year spotrate (0-1), withdrawn and invested same for (1-2) forward rate, same amount amount withdrawn and invested for (2-3) forward rate.
(0*2)2 = (0*1)(1*2)
(1 *2) = (1 + 0.88%)2 / (1 +0.37%)
= 1.38%
adding premium of 0.02% = 1.4%
(0*3)3 = (0*1)(1*2)(2*3)
(2*3) = (1 + 1.59%)3 / (1 + 1.4%) (1 + 0.37%)
= 3.01%
adding premium = 3.04%