Question

Suppose the liquidity premium on a two year bond is currently (3/2019) .8%, the current (3/2019)...

Suppose the liquidity premium on a two year bond is currently (3/2019) .8%, the current (3/2019) yield to maturity on a one year bond is 2.53%, and the yield curve is flat. Then, according to the liquidity premium hypothesis, the yield to maturity on a bond that matures in one year that is expected next year (3/2020) is ____%.  

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Answer #1

Given that the yield curve is flat that means for any time to maturity, the return of the bonds will be the same for investors if held till maturity.

According to the Liquid Preference Theory or The Liquidity Hypothesis, a liquidity premium is added to the interest rates in order to compensate investors for exposure to interest rate risk. Furthermore, the theory suggests that this liquidity premium is positively related to maturity.

Therefore YTM of Bond= 2.53%(as yield curve is flat)+0.8%=3.33%.

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