Liquidity Premium Hypothesis Suppose We Observe the Following Rates: ₁R₁

question 85

Multiple Choice

Liquidity Premium Hypothesis Suppose we observe the following rates: ₁R₁ = 8%, ₁R₂ = 10%, and E(₂r₁) = 8%. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L₂?

• A) 1.02%
• B) 4.04%
• C) 6.15%
• D) 12.03%

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Definitions:

Required Return

The minimum expected return investors demand for investing in a security or project.

Unlevered Return

A return on investment that doesn't account for debt, measuring the performance of an investment as if no borrowing took place.

Cost of Equity

The return a firm theoretically pays to its equity investors to compensate them for the risk they undertake by investing in the company.

Total Debt

The sum of all short-term and long-term liabilities owed by an entity.