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a. (2 pts.) What is the fact number two that the term structure of interest rates...

a. (2 pts.) What is the fact number two that the term structure of interest rates explains?

b. (6 pts.) Explain this fact using the liquidity premium theory.

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Answer #1

a) Term Structure of interest rates graphically illustrates the relationship between yield (interest rates) and different time periods. This is called the yield curve wand it helps to assess the state of the economy. In general, yields on securities increase with an increase in investment maturity, giving an upward sloping yield curve. This means that the interest rates on long term securities is higher than that offered on short term securities.

b) The above fact can be easily explained in terms of the liquidity premium theory which states that investors normally prefer to have liquid assets at their disposal so as to take care of their immediate financial needs. Hence, they are rewarded with an incentive (higher interest rates) for investing in long term securities as they are giving up on their liquidity preference.

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