Question

A. What is the basic difference between the Expectations Hypothesis and Liquidity Premium Theory? Which has a higher interest rate in a normal market?

B. If we have an “inverted yield curve”, what does the Expectations Hypothesis claim about long and short-term rates?

C. If you see a steep upward slope of the yield curve, are short term rates expected to rise or fall?

Answer 1

A. Expectation hypothesis theory advocates that long-term interest rates are determined by short term interest rates and expected futures whereas liquidity premium theory advocate that all the long term Bond should have a higher interest rates because they are having a lower liquidity associated with them and there should be a compensation with lower liquidity. Expectation theory will have a higher interest rate in the normal market

2. Inverted Yield curve means there will be an impending recession and short-term interest rates are going to fall but long term interest rate aur going to fall more than the short term interest rates and they will trade below the short term interest rate

3. I will expect that short term rates are expected to increase due to upward sloping curve.