A one-year bond has an interest rate of 3% and is expected to fall to 2.5% next year and 2% in two years. The term premium for a two-year bond is 0.3% and for a three-year bond is 0.5%
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 (3% + 2.5%)/2 + 0.3% = 3.05%. A three-year bond will have an interest rate of (3% + 2.5%+2%)/3 + 0.5% = 3%.
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