Question

A. Please use the the following information for a and b: The current four-year interest rate is 6.25% The current one-year interest rate is 3.0% The expected one-year rate for one year from now is 5.0% The expected one-year rate for two years from now is 6.5% a. Assuming the Expections Hypothesis is correct, what is the expected one-year rate for three years from now? (6 Points) b. Assuming the Liquidity Premium Theory is correct, and, if the expected one year rate is 4.57% three years from now, what is the Liquidity Premium? (6 Points)

Answer 1

Solution:

A)

4 x S4 = S1 + 1F1 + 2F1 + 3F1

Here,

S4 - Current 4-year rate = 6.25%

S1 - Current 1-year rate = 3.0%

1F1 - one year rate one year from now = 5.0%

2F1 - one year rate two years from now = 6.5%

3F1 - one year rate three years from now = ?

4 x 6.25 = 3.0 + 5.0 + 6.5 + 3F1

25 = 14.5 + 3F1

=> 3F1 = 25 - 14.5

3F1 = 10.5

B)

Liquidity Premium = 10.5% - 4.57% = 5.63%