A one-year and two-year bonds currently pays 1.4% and 1.2%, 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%

Expected Interest Rate = 1.8%

Explanation:

The computation of the expected interest rate on a one year bond is shown below

Interest Rate expected in nth year would be

= (Sum of individual interest rates in n years) ÷ n + liquidity premium in nth year

1.6% = (1.2% + Expected Interest Rate) ÷ 2 + 0.1%

1.5% × 2 - 1.2%= Expected Interest Rate

Expected Interest Rate = 1.8%