Question

Suppose an investor observes a downward term structure of interest rate.  

What will the investor say about the future change of interest rate according to liquidity preference theory? Explain your argument. (10 marks)

Answer 1

According to the liquidity preference theory, investor will be demanding a higher rate of interest for the long-term securities because they will be having a lower liquidity and investor will be demanding a lower rate of interest for the short-term security because he knows that short-term securities are more liquid in nature so when there will be a downward term structure of interest rate it will mean that the long-term interest are lower than the short-term interest in the longer period of time.

Downward term structure of interest rate will be reflecting lower liquidity in future because the long-term interest rate are going to be lower than the short-term interest rate and it will not be according to the investors liquidation preference theory and he will not be prefering for the long term bonds because long term bonds will be offering him with a lower rate of interest in the longer period of time, and they even have a lower liquidity so investor will be shifting to the short term bonds as per the liquidation preference theory as these bonds will be offering him with the better rate of interest along with a better liquidity, so this downward yield curve is a reflection that investors will be preferring short term securities which have high liquidity and higher rate of interest during downward yield curve cycle.