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Liquidity Premium: Q2-Q12 We are going to calculate liquidity premium. In the first part, we...

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Liquidity Premium: Q2-Q12 We are going to calculate liquidity premium. In the first part, we assume that investors are indifferent between short-term and long-term bonds. That means they don't ask for a higher return when holding long-term bonds (i.e., f2 = E(r2)). In the second part, we assume that investors want to avoid liquidity risk. That means they are willing to hold long-term bonds only if they yield higher returns (i.e., f2 = E(r2) + liquidity premium). Suppose that today's rate is 11-6% and that the expected short rate for the following year is E[r2] = 7%. Consider a short-term investor who wishes to invest only for one year and she has two options: Buy a 1-year zero, hold it for a year, and receive its face value ($1,000) when it matures next year. Buy a 2-year zero, hold it for a year, and sell it at the end of the year. Option: 1-year zero What is her holding-period return

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