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%
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%)
Now we add the liquidity premium to it and it becomes-
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%
r=2.99% + 0.4% = 3.4%
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