Question

"One-year Treasury bills currently earn 2.90 percent. You expect that one year from now, one-year Treasury bill rates will increase to 3.35 percent. The liquidity premium on two-year securities is 0.085 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities (Round the percentage answer to 2 decimal places)?"

		3.12%
		3.13%
		Not possible to compute with the data provided
		2.11%
		3.17%

Answer 1

Sol:

One-year Treasury bills current rate = 2.90%

One year from now, expect one-year Treasury bill rates will increase to 3.35%

The liquidity premium (LP) on two-year securities is 0.085%

To determine current rate be on two-year Treasury securities:

Two year security rate = [(1 + One-year Treasury bills current rate) x (1 + Expect one-year Treasury bill rates + LP)]^0.5 - 1

Two year security rate = [(1 + 2.90%) x (1 + 3.35% + 0.085%)]^0.5 - 1

Two year security rate = [(1 + 0.0290) x (1.0335 + 0.00085)]^0.5 - 1

Two year security rate = (1.0290 x 1.03435)^0.5 - 1

Two year security rate = 1.031672 - 1 = 0.031672 or 3.17%

Therefore current rate be on two-year Treasury securities is 3.17%