# Liquidity Preference Theory Yield Curve

Hi,

I’ve come across a couple of questions regarding the shape of the YC under liquidity pref theory that got me a little confused. I’m hoping i’m not being stupid and not understanding the question…Why is one saying YC can be any shape and the other Upward Sloping?

Q1 What are the implications for the shape of the yield curve according to the liquidity theory? The yield curve:

A) must be upward sloping. B) may have any shape. C) is always flat

Answer was B - The liquidity theory holds that investors demand a premium to compensate them to interest rate exposure and the premium increases with maturity. Even after adding the premium to a steep downward sloping yield curve the result will still be downward sloping.

Q2 The liquidity premium theory of the term structure of interest rates projects that the normal shape of the yield curve will be:

A) variable. B) downward sloping. C) upward sloping.

Answer C - The liquidity theory holds that investors demand a premium to compensate them to interest rate exposure and the premium increases with maturity. By itself, the liquidity theory implies an upward sloping yield curve.

1. The yield curve could be upward sloping or downward sloping. Even if you add a liquidity premium it could still be negative sloping if the magnitude is large enough (rare).

2. NORMALLY you think of the yield curve as flat or upward sloping. It could be downward sloping, but NORMALLY it’s flat or upward. If you add an premium for liquidity the the flat curve would change into an upward sloping one.

There are many factors that will determine a yield, but we should always assume that it’s upward or flat becausethe theories try to explain why yield curves go up. (Look at a treasury note. 1 years always lower yield than 5, 10 more than 5, 30 more than 10)

Thanks - looks like i need to read the questions a little closer then!

Wow I don’t get how you people understand my sleepy English. 3 am in HK right now, but I am up watching the NBA playoffs. Suck to be in Asia and still love sports so much.