Which of the following are correct? i. The liquidity premium for a 2-year government bond is...

Which of the following are correct?
i. The liquidity premium for a 2-year government bond is higher than the liquidity premium for a 5-year government bond.
ii. The liquidity premium for a 3-year government bond is lower than the liquidity premium for a 3-year corporate bond.
iii. The expected return from holding an illiquid two year zero-coupon bond to maturity is higher than the expected return from buying a liquid one-year zero-coupon bond (and holding it to maturity) followed by investing in another liquid one-year zero coupon bond (and holding it to maturity).
iv. The expected one-year rate in one year's time is lower under the Liquidity Premium Hypothesis than the expected one-year rate in one year's time under the Pure Expectations Hypothesis (assuming that two-year bonds are illiquid and one-year bonds are liquid).

The correct answer is:

Solutions

Expert Solution

The liquidty premium of higher tenure bond will hold a higher liquidity premium.

The liquidty of governemnt bond is always higher than of corporate bond. Thus liquidity premium will be always lower.

The expected return of investing in illiquid bond will be higher than the expected return from buying liquid bonds of shorter tenure due to presence of liquidity premium.

The expected one-year rate in one year's time is higher under the Liquidity Premium Hypothesis than the expected one-year rate in one year's time under the Pure Expectations Hypothesis as longer tenure will hold more return in Liquidity Premium Hypothesis than Pure Expectations Hypothesis

thus, correct answer is ii, iii

jeff jeffy answered 2 years ago

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