The liquidity premium theory suggests that long-term interest rates reflect both expected future short-term rates and a liquidity premium that compensates investors for holding longer-term bonds. According to this theory, the interest rate on a long-term bond is equal to the average of expected short-term rates over the bond's life, plus a liquidity premium.

Given:

• $R_{11} = 13.0\%$ (One-year rate observed today)
• $R_{21} = 16.0\%$ (Two-year rate observed today)
• $E(r_{12}) = 19.0\%$ (Expected one-year rate one year from now)

Using the formula under the liquidity premium theory for the two-year rate:

$R_{21} = \frac{R_{11} + E(r_{12})}{2} + LP_2$

Where:

• $R_{21}$ is the observed two-year rate.
• $R_{11}$ is the current one-year rate.
• $E(r_{12})$ is the expected one-year rate one year from now.
• $LP_2$ is the liquidity premium for the second year, which we need to find.

Now, rearrange the formula to solve for the liquidity premium $LP_2$:

$LP_2 = R_{21} - \frac{R_{11} + E(r_{12})}{2}$

Substitute the given values:

$LP_2 = 16.0\% - \frac{13.0\% + 19.0\%}{2}$

First, calculate the average of $R_{11}$ and $E(r_{12})$:

$\frac{13.0\% + 19.0\%}{2} = \frac{32.0\%}{2} = 16.0\%$

Now, find the liquidity premium:

$LP_2 = 16.0\% - 16.0\% = 0.0\%$

Conclusion:

The liquidity premium for year 2 is 0.0%.

Would you like further details or have any questions?

Here are some related questions for further exploration:

1. What is the liquidity premium for longer time horizons like 3 or 5 years?
2. How does the liquidity premium theory differ from the expectations theory?
3. Can the liquidity premium be negative in some cases?
4. How do central banks influence the liquidity premium through monetary policy?
5. What are some real-world examples where the liquidity premium plays a significant role in bond markets?

Tip: Liquidity premiums often increase with longer bond durations due to the higher uncertainty and risk involved over time.