Question

What does the liquidity preferences framework suggest about the bond market and the money market? Explain.

We can write the general return of a bond as R=i_c+g. What does this equation tell us? Explain.

The table below shows the expected interest and our short term preference on shorter term bonds. What are the interest rates on 2, 3, and 4 year bonds using the liquidity premium framework? What would the yield curve look like if you could plot it?

Year	Expected interest rate	Short term preference
1	2
2	3	0.075
3	4	0.1
4	3	0.125

Answer 1

I am answering the first question as per the guidelines of Chegg. It is being requested to post separate questions.

1. Liquidity preference framework advocates that investors are always looking to prefer for those assets which are having a higher liquidity because that will be offering them with the higher security of getting exit at any point of time so investors according to the liquidity preference theory will be preferring for short term bonds than the longer term bonds and they will be always trying to ask for a higher rate of interest for investment into liquid assets because they have a risk associated with a liquidity and they want to get compensated for that risk.

Money market are generally trading in short-term securities whereas bond market will be trading in long-term securities,So, investors will always have a preference for the money market because it will be offering them with the higher liquidity and they can even take securities for lower rate of interest but investors will not be preferring for bond market because it will be offering the with longer term securities and they will be always asking a premium in interest rate because that premium would be acting as a compensation for the risk related to lower liquidity of the longer term bonds.

Hence, Money Market instruments would be reflecting higher liquidity and investors will have a preference for them than the bond markets.