Question

Suppose you invest for one year. You consider buying a 3-year zero coupon bond and selling it after one year, or a 5% coupon bond for 3 years, coupons paid once a year and selling it after one year The 1-year interest rate is 2%. The forward rate1f3 is 2.5%. The forward rate 1f2 is 2.25%

Under the liquidity preference theory, assuming that the liquidity risk premium (LPR) on a 2-year zero bond is 0.3%, is the 1 -year interest rate expected to rise or fall next year?

Answer 1

1 Year Interest Rate = 2%

2 Year Liquidity Premium = 0.3%

Under the Liquidity Preference Theory, the investor would want to be compensated with an additional 0.3% for one extra year of holding the bond, which translates into a 2 Year Interest Rate of 2.3%.

3 Year Interest Rate 1 Year from now (1f3) = 2.5%

2 Year Interest Rate 1 Year from now (1f2) = 2.25%

As evident from the figures above, and the investors preference for selling after 1 year, it can be inferred that interest rates are expected to fall.