Question

The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.

Year	One-Year Bond Rate	Multiyear Bond Rate
1	1%	1%
2	2%	2.5%
3	3%	4%
4	3.5%	5%
5	4%	6%

Answer 1

Answer :-

In order to calculate the liquidity premium for a given year, we have to subtract the average of expected one year interest rates over that horizon from the current rate on a multi-year horizon bond.

Therefore, the liquidity premium for each year is calculated below ;

For year 1 ;

L11= 1-1/1 = 0

L11 = 0

For 2 years ;

L21 = 2.5 - (2+1)/2 = 2.5 - 1.5 = 1%

L21 = 1%

For 3 years ;

L31 = 4 - (3+2+1)/3 = 4 - 2 = 2%

L31 = 2%

For 4 years ;

L41 = 5 - (3.5+3+2+1)/4 = 5 - 2.375 = 2.625%

L41 = 2.625%

For 5 years ;

L51 = 6 - (4+3.5+3+2+1)/5 = 6 - 2.7 = 3.3 %

L51 = 3.3%