Question

# Your client also wants to determine the Liquidity of his investment by using Liquidity Premium Theory....

Your client also wants to determine the Liquidity of his investment by using Liquidity Premium Theory. Base on the question 1, it shows the information as follows:

1R1 = 1.50%
E(2r1) = 2.5%
E(3r1) = 3.0%
E(4r1) = 3.5%
E(5r1) = 4.5%

In addition, you charge a liquidity premium on longer-term securities such that:

L2 = 0.15%
L3 = 0.25%
L4   = 0.35%
L5 = 0.40%

Instructions:

1] Please using the Liquidity Premium Theory of the Term Structure of Interest Rates.
2] Please provide a clear calculation and brief explanation to support your calculation.

1R1 means the interest rate for the next one year. 2R1 means the future one-year interest rate after one year. L2 means the liquidity premium for the debt terminating after 2 years.

Hence, the spot interest rate after 2 years (without the liquidity premium) will be-

(1+0.015)x(1+0.025) = (1+r)^2

hence, r= 1.998%(=2%)

Spot 2-year interest rate = 2.15%

Similarly, we calculate the three-year spot rate-

1.015 x 1.025 x 1.03 = (1+r)^3

r = 2.33%

Adding liquidity premium, we get the 3-year rate = 2.33 + 0.25 = 2.58%

Similarly, we calculate the 4-year rate.

1.015 x 1.025 x 1.03 x 1.035 = (1+r)^4

r= 2.62%; Add liquidity premium, r = 2.62 + 0.35 = 2.97%

5-year rate-

r=2.99% + 0.4% = 3.4%