The table below shows current and expected future one-year...

The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. $$\begin{array}{|ccc|} \hline & \text { One-Year } & \text { Multiyear } \\ \text { Year } & \text { Bond Rate } & \text { Bond Rate } \\ \hline 1 & 2 \% & 2 \% \\ 2 & 5 \% & 4 \% \\ 3 & 7 \% & 5 \% \\ 4 & 8 \% & 7 \% \\ 5 & 10 \% & 10 \% \\ \hline \end{array}$$

The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
$$\begin{array}{|ccc|}
\hline & \text { One-Year } & \text { Multiyear } \\
\text { Year } & \text { Bond Rate } & \text { Bond Rate } \\
\hline 1 & 2 \% & 2 \% \\
2 & 5 \% & 4 \% \\
3 & 7 \% & 5 \% \\
4 & 8 \% & 7 \% \\
5 & 10 \% & 10 \% \\
\hline
\end{array}$$

Labs

Want to see this concept in action?

NEW

Explore this concept interactively to see how it behaves as you change inputs.

View Labs

Key Concepts

Liquidity Premium

The liquidity premium is the extra yield that investors demand for holding longer-term bonds which are typically less liquid and more sensitive to changes in interest rates compared to shorter-term securities. It represents the additional compensation over the expected average future short-term rates (predicted by the expectations hypothesis) to make up for the increased risk and lower tradability.

Expectations Hypothesis

The expectations hypothesis is a theory that suggests the long-term interest rates reflect the market’s forecast of future short-term interest rates. Under this theory, if no liquidity or other risk premiums were present, the yield on a multiyear bond would equal the geometric average of the current and expected future one-year rates.

Term Structure of Interest Rates

The term structure of interest rates describes the relationship between the yields on bonds and their maturities. It is typically illustrated by the yield curve, which shows how yields vary with different time horizons. A key component of understanding bond pricing, it helps in distinguishing between the pure expectations component and additional premiums like the liquidity premium.

Please give Ace some feedback