Question

Explain (in no more than two paragraphs for each) which of the following statements are true or false.

A. The traditional liquidity premium theory states that long-term interest rates are greater than the average of current and expected future short-term interest rates

.B. According to the market segmentation theory, short-term investors will not normally switch to intermediate- or long-term investments.

C. According to the liquidity premium theory, investors preferring long-term bonds over short-term bonds would require lower liquidity premium.

Answer 1

A.The statement is TRUE.

Investors prefer to hold short-term securities since they are liquid and can be converted to cash quickly. The liquidity premium theory states that investors will hold long-term maturities only it they are offered at a premium to compensate for the uncertainty of future value. Investors must be offered a liquidity premium to buy long-term securities since they have a high risk of capital loss. Therefore, the long-term interest rates are higher.

B.The statement is TRUE.

Market segmentation theory states that investor have a preference for a specific maturity. Investors are unlikely to switch from one maturity to another without adequate compensation. Investors are likely to prefer short-term bonds over long-term bonds.

C.The statement is FALSE.

Investors prefer short-term bonds over long term bonds since they less interest rate risk. They would prefer long term bonds only if they are paid a risk premium.

I hope that was helpful :)