One-year Treasury bills currently earn 4.65 percent. You expect that one year from now, one-year...

Question:

One-year Treasury bills currently earn 4.65 percent. You expect that one year from now, one-year Treasury bill rates will increase to 4.80 percent. The liquidity premium on two-year securities is .100 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities?

a. 4.7750%

b. 3.1830%

c. 9.5500%

d. 4.7250%

Bond Premiums:

Long-term bonds often attract a premium over short-term bonds. This incentivizes investors to invest in a long term bond, rather than investing and subsequently re-investing in short-term bonds for the same return.

Answer and Explanation:

One-year Treasury bills currently earn 4.65 percent. You expect that one year from now, one-year Treasury bill rates will increase to 4.80 percent. The liquidity premium on two-year securities is .100 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities?

a. 4.7750%

b. 3.1830%

c. 9.5500%

d. 4.7250%

We can determine the amount of a two-year security by first determining the rate which would be obtained with two one-year securities. This is determined as the average rate: (4.65 + 4.8) / 2 = 4.725%. However, a premium is attached to the two-year securities of 0.1%. This amount must be apportioned over the two-year period. Therefore, the amount is equal to 4.725% + (0.1/2) = 4.775%


Learn more about this topic:

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How to Calculate Risk Premium: Definition & Formula

from Financial Accounting: Help and Review

Chapter 5 / Lesson 26
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