Liquidity Preference Teory

Based on liquidity preference theory, Yield curve should be: 1) Upward sloping 2) Flat, Upward or downward. Schweser says 'Upward sloping" I thought that yield curve points can be consistent with a downward sloping curve if an expected decrease in short-term rates outweighs the term premium. and maybe even flat? so answer should be ‘Flat, Upward or downward’ what do you all think?

It says ‘based on liquidity preference theory’ which is the key to the answer. Here’s the quick wikipedia version of the theory - "The Liquidity Preference Theory, an offshoot of the Pure Expectations Theory, asserts that long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds, called the term premium or the liquidity premium. " This implies that as term to maturity increases, yield increases, thus 1) upward sloping.

Liquidity Preference theory is consistent with the upward sloping yield curve because investors feel they should be compensated for the extra liquidity risk of holding a bond for a longer period of time.

many thanks

Don’t take the above explanations to mean that the yield curve can’t be flat or downward sloping based on the liquidity preference theory. The curve can still be downward sloping if short-term interest rates are forecasted to fall far enough.

Basically, the question means “other things equal,” the effect of the liquidity preference theory is to make the curve slope (more) upwards. But it’s a badly worded question. The main point is that the liquidity preference theory can’t explain anything but an upwards sloping curve. To explain flat and downward sloping, you need to bring in the other theories (simple expectations and preferred habitat). None of the theories are mutually exclusive, although you can debate how much of an effect each one has on the yield curve.

I disagree, the other theories need not be used. A downward sloping curve can be fully explained by pure expectations. This seems like stupid question, as I remember coming across a question in the CFA texts which stated a downward sloping yeild curve is consistent with all yield curve theories. They are essentially saying that pure expectation theory “should” produce an upward sloping curve, which may be true when expectations ex. liquidity are for higher future rates but not true when expectations are for lower future rates. In there opinion the yield curve should slope up so your wrong !

Theoretically it should be upward sloping due to the liquidity premium, YET a downturn can easily result in an inverted yield curve.

Chicago_Bull Wrote: ------------------------------------------------------- > Based on liquidity preference theory, Yield curve > should be: > > 1) Upward sloping > 2) Flat, Upward or downward. > > Schweser says 'Upward sloping" > > I thought that yield curve points can be > consistent with a downward sloping curve if an > expected decrease in short-term rates outweighs > the term premium. > and maybe even flat? > > so answer should be ‘Flat, Upward or downward’ > > what do you all think? An investor would like more $$$ to be compensated for being without their cash for a longer period of time. As another poster stated, you have a higher preference for liquidity and you’ll demand less yield because of it.

jonnyc Wrote: ------------------------------------------------------- > I disagree, the other theories need not be used. A > downward sloping curve can be fully explained by > pure expectations. This seems like stupid > question, as I remember coming across a question > in the CFA texts which stated a downward sloping > yeild curve is consistent with all yield curve > theories. They are essentially saying that pure > expectation theory “should” produce an upward > sloping curve, which may be true when expectations > ex. liquidity are for higher future rates but not > true when expectations are for lower future rates. > In there opinion the yield curve should slope up > so your wrong ! I misstated something in my original post: it meant that “liquidity preference theory BY ITSELF can only explain an upwards sloping yield curve.” In order to explain a flat or downward sloping yield curve, you must use either expectations or preferred habitat. I think what the readings probably say (haven’t read them in a while) is that a downward sloping yield curve does not - in itself - discredit the liquidity theory, since expectations or preferred habitat can cause downward sloping curves and people will still prefer more for locking up their money longer… just not enough to counteract the effects of expectations or habitat preferences.