Question

Suppose we observe the following rates: 1R1 = 13 percent, 1R2 = 16 percent, and E(2r1) = 10 percent. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L2?

a)8.7 percent

b)9.1 percent

c)9.7 percent

d)10.0 percent

Answer 1

Answer:

b)9.1 percent

Explanation:

Data provided in the question:

1R1 = 13 percent,

1R2 = 16 percent3

E(2r1) = 10 percent

Now,

The liquidity premium theory is given as:

1 + 1R2 = $[ ( 1 + 1R1)\times(1 + E(2r1) + L2 )]^{\frac{1}{n}}$

for year 2, n = 2

Thus,

1 + 0.16 = $[ ( 1 + 0.13)\times(1 + 0.10 + L2 )]^{\frac{1}{2}}$

or

1.16² = [ 1.13 × ( 1.10 + L2)]

or

1.191  = 1.10 + L2

or

1.191 - 1.10 = L2

or

L2 = 0.091

or

L = 0.091 × 100% = 9.1%

b)9.1 percent