Question

The 1-year rate is currently 3%, and the expected 1-year rate a year from now is 3%. If the liquidity preference theory holds and the liquidity premium for the 2-year rate is 0.3%, what should the 2-year rate be? (Assume that the liquidity premium for the 1-year rate is 0.0%) Please express your answer in percent rounded to the nearest basis point.

Answer 1

Current 1 year rate = 3%

Expected 1 year, a year from now = 3%

Liquidity premium for a 2 year rate = 0.3%

(1 + 2 year rate)² = (1 +  Current 1 year rate) * (1 + Expected 1 year, a year from now)

(1 + 2 year rate)² = (1 + 3%) * (1 + 3%)

(1 + 2 year rate)² = 1.0609

  (1 + 2 year rate) = 1.03

2 year rate = 3%

Adding Liquidity premium for a 2 year rate we get

2 year rate with Liquidity premium =  2 year rate + Liquidity premium for a 2 year rate

2 year rate with Liquidity premium = 3% + 0.3%

2 year rate with Liquidity premium = 3.3%