To determine the liquidity premium on the five-year T-bond, we use the following method:

Step 1: Calculate the Average Expected One-Year T-Bill Rates

The expected one-year T-bill rates over the next five years are given as: 4%, 5%, 6%, 6.5%, and 7%. The average of these rates is calculated as:

$\text{Average Expected Rate} = \frac{4\% + 5\% + 6\% + 6.5\% + 7\%}{5} = \frac{28.5\%}{5} = 5.7\%$

Step 2: Compare with the Yield on the Five-Year T-Bond

The yield on the five-year T-bond is given as 9.5%. We compare this yield with the average expected one-year T-bill rates. The difference between the T-bond yield and the average expected T-bill rate represents both the liquidity premium and any risk premium that might be present.

$\text{Liquidity Premium} = \text{T-Bond Yield} - \text{Average Expected Rate}$ $\text{Liquidity Premium} = 9.5\% - 5.7\% = 3.8\%$

Thus, the liquidity premium on this bond is 3.8%.

Would you like more details or have any questions? Here are some related questions:

1. How do liquidity premiums impact bond prices in general?
2. Why might long-term bonds have higher liquidity premiums than short-term bonds?
3. How does the expectation theory relate to T-bond yields?
4. What is the significance of the average expected T-bill rate in bond yield calculations?
5. How does inflation risk influence the yield on bonds?

Tip: Long-term bonds typically carry higher liquidity premiums because investors demand compensation for the increased uncertainty over a longer investment period.