Liquidity Preference Theory

4Q- 98 According to the Liquidity Preference Theory, is the term structure of interest rates most likely related to Expectations about future rates? and Interest rate risk?


Up because according to this theory, the term structure of interest rates, investors are risk-averse and will demand a premium for securities with longer maturities

By definition, liquidity preference theory is determined by: 1. expectations about future interest rates 2. a yield premium for interest rate risk (straight from the text)

"I would really like to spend my money now than invest it in your business and wait for a return in the future, unless…well, unless you are willing to pay a premium for my money " says the Investor. That’s liquidity preference theory. And businesses pay a premium to get the long-term investment (that’s expectations are future rates going up). But as maturities go longer and longer, the premium paid grows, but at a decreasing rate, as over longer and longer terms volatility of interest rates decreases (downward pressure). That’s expectations for forward rates to go up, interest risk to go down.

upward curve is predicted by liquidity preference… since now is better than then, so short term rates should be lower than long-term rates.

liquidity theory says a premimum on top of expected interest rate. if interest rate is decreasing the added premium may still give any shape to yield curve. So per se it doesn’t tell anything about the shape of the curve. S

Nice S this is correct

Liquidity premium theory, is basically people prefer liquid assets. You will want liquid assets more than non liquid assets, and short term assets are more liquid than long term assets, hence short term assets have a higher demand than long term assets, higher demand equals higher price, hence lower yield for short term, than for long term. so liquidity premium in effect incorporates, a) expectations about interest rates b) interest rate premium for longer maturities.