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Show working please Consider the same short-term interest rates as in problem 4 above. If the...

Show working please

Consider the same short-term interest rates as in problem 4 above. If the yield on a discount bond that matures in 4 years is 8.25%, then according to liquidity premium theory, the premium attached to the 4 year discount bond is?

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Analysts predict that short-term interest rates over the next 4 years will be as follows: 13%, 2%, 7%, and 10%, respectively. According to expectations theory, the yield on a discount bond with a three year maturity will be ____ and yield on bond with a four year maturity will be ____.

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Answer #1

According to expectations theory, the short term interest rates in the future should on average determine the yield of the bond for a particular period.

Hence, with the 4 given interest rates, the expected yield of the 4 year bond will be

= (1.0792-1) * 100

= 7.92%

The liquidity premium theory, presents a more practical approach to estimating the bond yield. It takes into consideration the interest rate risk over the 4 years to which the investor is exposed to. So, it includes a liquidity premium over the expectations theory yield to compensate the investor for interest rate risk. Such a bond also guarantees liquidity in 4 years and hence charges more for it.

So,

Liquidity premium = Actual 4-year bond yield - Bond Yield as per expectations theory

Liquidity premium = 8.25% - 7.92%

Liquidity premium = 0.33%

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