Question

One-year Treasury bills currently earn 3.25 percent. You expect that one year from now, 1-year Treasury bill rates will increase to 3.45 percent and that two years from now, 1-year Treasury bill rates will increase to 3.95 percent. The liquidity premium on 2-year securities is 0.10 percent and on 3-year securities is 0.20 percent. If the liquidity premium theory is correct, what should the current rate be on 3-year Treasury securities? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

Ans:- As per Liquidity Premium theory the current rate on a 3- year security is given by

1R3 = [ ( 1 + 1R1) * ( 1 + E(2r1) + L2) * ( 1 + E(3r1) + L3)] ^1/3 - 1, where 1R1 is the actual current one year rate today and E(2r1) and E(3r1) is the expected rate of security for year 1 and 2 from now, L2 and L3 are the liquidity premium.

1R3 = [ ( 1 + 0.0325) * ( 1 + 0.0345 + 0.001) * ( 1 + 0.0395 + 0.002) ] ^1/3 - 1

= 0.03464 *100 = 3.65%.

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