Question

Q1: The yield to maturity last Wednesday on a bond that matures in March of 2020 was 2.53%. On the same day, a bond that matures in May of 2039 was 2.82%.

A.This is an example of a yield curve of the typical shape.

B.This is evidence against the liquidity premium hypothesis

C.If the pure expectations hypothesis were true, this is evidence that the market expects short term rates to fall

D.This is an example of the liquidity premium hypothesis

Q2: Agents may reduce their exposure to risk if they ________________________ and this creates a preferred habitat for different types of agents and motivates the market segmentation hypothesis of the term structure of interest rates.

A.maximize their return and minimize their risk

B.hold a portfolio of assets with high liquidity.

C.equalize returns across all their assets

D.hold assets with the same maturities as their liabilities

Answer 1

Q1. Answer is D. This is an example of the liquidity premium hypothesis.

Liquidity Premium hypothesis means when an investor expects that the interest rate will rise in future of the longer maturity bond and he will get liquidity premium for it as longer maturity bonds are more risky. If this assumption is true he will earn liquidity premium on his investment in longer maturity bonds over short duration bonds with low yield.

Q2. Answer is A. maximize their return and minimize their risk

This is because holding a diversified portfolio with different maturities and interest rates as defined by market segmentation will reduce risk of holding one type of securities. Thus, if this hypothesis gets true then agents may be able to reduce their risk by investing in different securities with different maturities and interest rates.