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Chapter 6: Q. 25 (page 189)

The table below shows current and expected future one-year interest rates, as well as current interest rates on multi-year bonds. Use the table to calculate the liquidity premium for each multiyear bond.

Short Answer

Expert verified

The multiyear bond rate is subtracted from the average of the one-year bond rates for each of the years considered.

Step by step solution

01

Definition

A liquidity premium is an additional return expected by investors for instruments that are not easily traded. It could not be easily converted into cash by selling at a fair price in the financial market. Long-term interest rates include a premium for holding a bond for an extended period of time.

02

Explanation

The liquidity premium could be calculated as:

For each year, the given multiyear bond rate is being subtracted from the average of one-year bond rates of each of the years is taken into consideration.

I11=2-21=0I21=4-2+42=1%I31=6-2+4+53=2.33%I41=9-2+4+5+84=4.25%I51=12-2+4+5+8+115=6%Hence,theliquiditypremiumsareI11=0%,I21=1%,I31=2.33%,I41=4.25%,I51=6%

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Most popular questions from this chapter

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curves for the following paths of one-year interest rates over the next four years:

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b.7%;5%;3%;5%

How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?

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