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.