Suppose we observe the following rates: 1 R 1 = 0.85%, 1 R 2 = 1.30%, and E( 2 r

Question

Suppose we observe the following rates: 1R1 = 0.85%, 1R2 = 1.30%, and E(2r1) = 0.943%. If the liquidity premium theory of the term structure of risk-free rates holds, what is the liquidity premium for year 2, L2?(Do not round intermediate calculations and round your answer to 3 decimal places.)

Suppose we observe the following rates: 1R1 = 0.85%, 1R2 = 1.30%, and E(2r1) = 0.943%. If the liquidity premium theory of the term structure of risk-free rates holds, what is the liquidity premium for year 2, L2?(Do not round intermediate calculations and round your answer to 3 decimal places.)

Explanation / Answer

1+1R2= (1+1R1)(1+E(2R1)+L2)1/2

1.013=(1.0085)(1+0.00943+L2)1/2

(1.013)2=(1.0085)(1+0.00943+L2)

(1.013)2/(1.0085) = (1+0.00943+L2)

(1.013)2/(1.0085) -1.00943 = L2

L2 = 0.008090 or 0.809%

  Liquidity premium = 0.809%

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