Schweser Q bank Debt Question

here is the question A portfolio manager who believed in the liquidity premium theory would expect : A) long term securities to offer higher returns than short term securities. B) rational investors to pay a price premium for short term securties. C) all of the the choices are correct D) long term rates to be higher than investors expections of future rates, because of the liquidity premium. ans. is C my question has to do with choice B. I am drawing a blank on why this would be so since I would require a premium to invest of any length of time. thanks

Assume it’s a yield curve of zero coupon bonds…these will all be bought at a discount and will mature at 100. For the theory to hold that shorter maturity bonds yield less than longer maturity bonds the short bond MUST trade at a higher price. For example, a one month zero coupon maturity is likely to be trading near par…say $99.90 because it only has one month to go and it will be redeemed at par. Your return on the zero coupon is entirely comprised of accretion of your discount. The 30 YEAR zero on the same curve is likely to be trading near $20 as the 30 year buyer demands more yield…the only way to get more yield on the zero is to drop the price. Schweser is coming up with a pretty ignorant way to ask a question. They really don’t give you enough information in the question to answer it…they force you to assume that the coupons are the same on all maturities along the curve. For example they make no mention of the coupon structure that makes up the curve in question. Answer B would not work on the current Treasury yield curve because there are different coupons for the various maturities. IE the current 2 year is a 3.125 coupon priced at 100-11…compare that to the 10 year with a coupon of 4.25 and a price of 102-03. You will immediately notice that although there is a positive slope to the curve the buyer of the 2 year is not paying a price premium…this is because he’s got a coupon that is much lower than that of the 10 year. In other words…you don’t have to pay a price premium…you can just lower the coupon and the theory still works. Schweser isn’t immune from getting things wrong. I caught them on a similar question on L1, they apologized and fixed it…when you write 10,000 questions a year they can’t all be right.

greenspan, Thanks for a great response.