A one-year bond currently pays 5% interest.It's expected that it will pay 4.5% next year and 4% the following year.The two-year term premium is 0.2% while the three-year term premium is 0.35%.What is the interest rate on a three-year bond according to the liquidity premium theory?
A) 4.5%
B) 4.68%
C) 4.85%
D) 5.05%

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, the interest rate on a three-year bond is equal to the average of expected one-year rates over the next three years plus the term premium for a three-year bond.
 
Expected one-year rate for next year: 4.5%
Expected one-year rate for the year after next year: 4%
Expected one-year rate for the third year: unknown
 
The average of the expected one-year rates over the next three years is (4.5% + 4% + X) / 3 = (4.5 + 4 + X) / 3, where X is the expected one-year rate for the third year. 
 
The term premium for a three-year bond is 0.35%.
 
According to the liquidity premium theory, the interest rate on a three-year bond is (4.5 + 4 + X) / 3 + 0.35%, so we need to solve for X. 
 
(4.5 + 4 + X) / 3 + 0.35% = 5%
 
Solving for X, we get X = 4.85%, so the interest rate on a three-year bond according to the liquidity premium theory is 4.85%. Therefore, the answer is C.

A One-Year Bond Currently Pays 5% Interest