Question

1. The market rate of interest on 2 year bonds is 6.25% while the rate on a one-year bond maturing on one year is 5.50%. The forward rate on a one-year bond one year from now is 6.5%. What is the liquidity premium to induce investors to hold the 2-year bond?

Answer 1

Investors prefer short term bonds to long term bonds owing to greater liquidity in short term bonds. So, there must be a liquidity premium associated with long term bonds rate for compensating investors to take up long term bonds.

Given that rate on a one year bond is 5.5% and forward rate on a year bond one year from now is 6.5%. Market rate on 2 years bonds is 6.25%

Let the liquidity premium be L.

Then (1+5.5%)*(1+6.5%)= (1+6.25%)^2 + L

1.123575= 1.12890625+L

So, L= 1.12890625-1.123575

L= 0.00533125= 0.533%

So, the liquidity premium to induce investors to hold 2-year bond is 0.533%