Under the liquidity premium theory of the term structure of


ou are given the following information:

Current interest rate on a 1 year T-bond (1R1) =       2.0%

Current interest rate on a 2 year T-bond (1R2) =       3.5%

Current interest rate on a 3 year T-bond (1R3) =       5.5%

Current interest rate on a 4 year T-bond (1R3) =       6.2%

Required liquidity risk premia for a:

1-year bond (l1) = 0%

2-year bond (l2) = 0.10%

3-year bond (l3) = 0.30%

4-year bond (l3) = 0.40%

Under the Liquidity Premium Theory of the term structure of interest rates, what is the expected 3-year forward rate at the beginning of year 2 (2f3)? (Use geometric average.)

Please show all work to get credit and explain how you got there. I'm genuinely confused on how to do this problem.

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Financial Management: Under the liquidity premium theory of the term structure of
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