Question

We studied several different theories of the yield curve. Which of the following statements is most likely correct?

a. The liquidity premium version of the expectations theory cannot explain a flat term structure of interest rates

b. The pure expectations theory suggests that an upward-sloping term structure of interest rates is a consequence of investors expecting short-term rates to remain unchanged for a period of time, followed by investors expecting short-term rates to rise for a period of time

c. The liquidity premium version of the expectations theory suggests that a downward-sloping term structure of interest rates is due to declining expected short-term rates, and although there is a maturity premium to consider, it is not large enough to offset the expected decline in short-term rates.

Answer 1

a. is correct. Liquidity preference theory is based on the premise that investors prefer short-term horizon because the interest rate risk is higher in long-term horizon. The investors should be compensated for this risk if they chose a long-term horizon. Hence the yield curve will be upward sloping. It cannot explain a flat yield curve.

b. is not correct. upward sloping yield curve is a result of expected increase in inflation rate and interest rate in the future.

c. is not correct. Liquidity preference theory cannot explain a downward-slopping curve.