Question

if 1 year interest rates for the next three years are expected to be 6,4 and 5 percent and the 3!year term premium is 1 percent, than the 3 year bond rate will be

Answer 1

Solution:

1 year interest rate for the next three years are 6%, 4% and 5% respectively.

The premium is paid to the investor for holding long terms bond. In this case the premium is paid in the third year. So according to the liquidity premium theory

the 3 year bond rate = Avearage of expected future terms rate + premium paid

= (6%+4%+5%)/3 + 1%

= 6%

*Things to remember -The yeild curve of liquidity premium theory is generally slope upwards with rare exception of flat or downward slope.

* In the given question there is a symbol ! after 3. I think it must be a typo mistake.