Question

A report about the importance of retirement savings causes all bond purchasers to become long-term investors, increasing their investment horizons. According to liquidity preference theory, how would this change the yield curve?

1. Yield curve becomes relatively more upward sloping

2. Yield curve becomes relatively more downward sloping

3. Yield curve unchanged

Answer 1

Solution:

Liquidity preference theory suggest that an investor should demand a higher interest rate on securities with long term maturities that carry greater risk because investors prefer cash or other highly liquid holdings.

In other words,higher the maturity period,higher the yield demanded.

Accordingly,when bond purchaser become long term investor,they would demand higher yield as per liquidity preference theory,therefore yield curve becomes relatively more upward sloping.Since the upward sloping reflects higher interest rate.

Thus correct answer is Option 1.