Based on economists forecasts and analysis 1year Treasury bi

Based on economists’ forecasts and analysis, 1-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows: R1 = 0.45 % E(2r1) = 1.60 % L2 = 0.06 % E(3r1) = 1.70 % L3 = 0.12 % E(4r1) = 2.00 % L4 = 0.14 % Using the liquidity premium theory, determine the current (long-term) rates. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Solution

nsig liquidity premium theory,

Interest rate on 2 year bond = (R1+E(2r1))/2 + L2 = (0.45+1.6)/2 + 0.06 =1.09%

Interest rate on 3 year bond = (R1+E(2r1)+E(3r1))/3 +L3 = (0.45+1.6+1.7)/3 + 0.12 = 1.37%

Interest rate on 4 year bond = (R1+E(2r1)+E(3r1)+E(4r1))/4 + L4 = (0.45+1.6+1.7+2)/4 + 0.14 = 1.58%

In this method, first the average of short term rates is taken then in that resulting rate the liquidity premium for the corresponding time period is added (for example for 2 year rate, L2 is added).