Under the liquidity theory, if the yield curve is flat, the short term interest rate: a. increase b. decrease c. remain unchanged
b
I went with B too
Agreed, i actually remember this question with detail because i wrote a message next to it in the booklet to the institute saying “the answer is appropriately b but it’s a crap question because if the liquidity preference is given an arbitrary value of zero it could be flat or decrease”.
i dont get it…why would it decrease?? If investors require a liquidy premium on top of pure expectations theory…shouldnt the yeild curve be upward sloping?? markCFAIL Wrote: ------------------------------------------------------- > Agreed, i actually remember this question with > detail because i wrote a message next to it in the > booklet to the institute saying “the answer is > appropriately b but it’s a crap question because > if the liquidity preference is given an arbitrary > value of zero it could be flat or decrease”.
i too put B , if yield curve remains flat , then short term interest rates has to go down to compensate for above yield interest rates in long term (due to less liquidity) . i don’t know if it’s actually true or not , nothing else made any sense because it’s written in CFAI that yield is complex average of spot rates , … i’m f***ing confused :O.
According to Mr. Schweser, ““An upward sloping yield curve can be consistent with the liquidity preference theory even with expectations of declining short term interest rates.”” Which apparently negates what all you people are mentioning or am i missing something ?
Yea this is confusing I likely got it wrong, I put that they would increase because I knew it was naturally an upward sloping line meaning long term rates are higher so to make it “flat” you would have to raise the short term end of the yield curve. I have no idea.
i think i went with decrease too…
Upward sloping could be liquidity preference like now. If there was a huge demand for short term instruments for safety reasons but rates were expected to come down in the future you could still have an upward sloping curve. As many investors have a preference to their given spot because of the rate that is given, the LPT states that the curve should be upward sloping as people need to be compensated for the excess time. The current answer is decrease as with a flat curve implies that rates are coming down but demand is not enough to outpace the supply in the short term.
Damn, add another one to the list I got wrong. It is decrease according to the book.
Paraguay, I think some of what you said about investors’ preference for their given spot is more relevant to the Market Segmentation Theory. The Liquidity Preference Theory simply posits a maturity premium above the expected rate. So an upwards sloping yield curve which under Pure Expectations indicates higher rates expected could in theory under LPT encompass lower or flat future rates expected. A flat curve, as in the question, under LPT (once you account for the maturity premium) indicates lower rates expected. The maturity premium is related to inflation expectations, so theoretically the premium could be nil, in which case flat future rates might be indicated. However, this is exceptional, and the answer was surely lower rates expected.
The LPT and MST are very close though. MST can explain kinked curves much better than LPT though. Answer is surely decrease though.
I went with A. Liquidity preference means even though it’s flat, a premium is still required so it will increase
billbelemy22 Wrote: ------------------------------------------------------- > I went with A. Liquidity preference means even > though it’s flat, a premium is still required so > it will increase You just explained why it will decrease…
billbelemy22, the yield curve was a given - we were being asked to interpret the implied expectations about the direction of short term interest rates. Accordingly to LPT the yield curve represents expectations + a premium. Once you subtract the premium the implication is that short term rates are headed downwards. In other words, the premium makes flat what would otherwise (under Pure Expectations) be a downwards sloping yield curve.