Question

The Wall Street Journal reports that the rate on three-year Treasury securities is 2.53 percent and the rate on four-year Treasury securities is 2.74 percent. The one-year interest rate expected in three years, E(4r1), is 3.22 percent. According to the liquidity premium hypotheses, what is the liquidity premium on the four-year Treasury security, L4?

Answer #2

Liquidity premium refers to the extra interest demanded by the investors for those securities which can not be readily liquidated at its fair value, before its maturity.

According to the problem:

Three-year interest rate (1r3) = 2.53%

Four-year interest rate (1r4) = 2.74%

Expected one-year interest rate expected in 3 years (E(4r1)) = 3.22%

According to the liquidity premium hypothesis,

(1+1r4)^4 = {(1+1r3)^3}*(1+E(4r1)+L4) where L4 = Liquidity Premium

Applying the given values in the formula, we get :

=> (1+0.0274)^4 = {(1+0.0253)^3}*(1+0.0322+L4)

=> 1.0274^4 = 1.0253^3*(1.0322+L4)

=> 1.1142 = 1.0778*(1.0322+L4)

=> 1.0337=1.0322+L4

which gives L4 as :

L4 = 1.0337-1.0322 = 0.0015 = 0.15%

Hence LiquidityPremium on the four-year treasury security is 0.15%

answered by: anonymous

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