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A 20-year U.S. Treasury bond has a 3.50 percent interest rate, while a same maturity corporate bond has a 5.25 percent interest rate. Real interest rates and inflation rate expectations would be the same for the two bonds. If a default risk premium of 1.50 percentage points is estimated for the corporate bond, determine the liquidity premium for the corporate bond.

Answer :

The liquidity premium for the corporate bond is 0.25%.

What is liquidity?

Any additional compensation needed to stimulate investment in assets that cannot be quickly and effectively converted into cash at fair market value is known as a liquidity premium. For instance, due to its relative illiquidity, a long-term bond will have a higher interest rate than a short-term bond.

Liquidity premium for corporate bond will be:

= 5.25 - 3.5 - 1.5

= Interest - Treasury - Default risk

= 0.25%.

Therefore, the liquidity is 1.25%.

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