A one-year bond has an interest rate of 0.2% and is expected to rise to 0.5% next year and 1.1% in two years. The term premium for a two-year bond is 0.1% and for a three-year bond is 0.25%
What are the interest rates on a two-year bond and three-year bond according to the liquidity premium theory?
A two-year bond will have an interest rate of (0.2 + 0.5)/2 + 0.1% = 0.45%. A three-year bond will have an interest rate of (0.2 + 0.5 + 1.1)./3 + 0.25% = 0.85%.
Economics
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