A one-year and two-year bonds currently pays 1.2% and 1.6%, respectively. What is the expected interest rate on a one-year bond next year according to the liquidity premium theory if the two-year term premium is 0.1%

Answer: 1.8%

Explanation:

Liquidity Premium theory posits that investors prefer more liquid securities to less liquid ones.

It can also be used to calculate expected interest by relating to other bond returns.

The formula is;

Interest Rate expected in nth year = (Sum of individual interest rates in n years) / n + Liquidity Premium in nth year

The premium provided is for the two - year bond and the return on the 2 year bond is also given.

Plugging the figures in gives;

1.6% = (1.2% + One year bond expected interest) / 2 + 0.1%

1.6% - 0.1% = (1.2% + interest) / 2

1.5% * 2 = 1.2% + interest

3% = 1.2% + interest

Interest = 3% - 1.2%

Interest = 1.8%