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One-year Treasury bills currently earn 2.50 percent. You expect that one year from now, 1-year Treasury bill rates will increase to 2.70 percent and that two years from now, 1-year Treasury bill rates will increase to 3.20 percent. The liquidity premium on 2-year securities is 0.05 percent and on 3-year securities is 0.15 percent. If the liquidity premium theory is correct, what should the current rate be on 3-year Treasury securities? (Do not round intermediate calculations. Round your answer to 2 decimal places.)Current Rate _____.__%

Question

One-year Treasury bills currently earn 2.50 percent. You expect that one year from now, 1-year Treasury bill rates will increase to 2.70 percent and that two years from now, 1-year Treasury bill rates will increase to 3.20 percent. The liquidity premium on 2-year securities is 0.05 percent and on 3-year securities is 0.15 percent. If the liquidity premium theory is correct, what should the current rate be on 3-year Treasury securities? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Current Rate _____.__%

check_circleAnswer
Step 1

As per the  liquidity premium hypothesis, an investor will hold bonds with long term maturity if the bonds are offered at a premium that will compensate the future uncertainty in their value. 

Step 2
IR3=((1+1R1)x(1+E(2R1)+L2)x(1+E(3R1)+L3))(1-n) -1
IR-Current rate on the 1 year treasury bills.
E(2RI) Expected rate of 1 year treasury bill one year from now
L2 Liquidity premium on 2 year securities
E(3RI)-Expected rate of 1 year treasury bill two years from now
L3-=Liquidity premium on 3 year securities
IR3 refers to the current rate
Here, n refers to the number of years and is equal to 3.
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IR3=((1+1R1)x(1+E(2R1)+L2)x(1+E(3R1)+L3))(1-n) -1 IR-Current rate on the 1 year treasury bills. E(2RI) Expected rate of 1 year treasury bill one year from now L2 Liquidity premium on 2 year securities E(3RI)-Expected rate of 1 year treasury bill two years from now L3-=Liquidity premium on 3 year securities IR3 refers to the current rate Here, n refers to the number of years and is equal to 3.

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Step 3

Substituting the va...

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