Question

What is the liquidity premium theory? How does this theory combine the features of pure expectations theory and market segmentation theory? What are the implications of the same?

Answer 1

The liquidity premium theory states that bond investors prefer highly liquid, short-dated securities that can be sold quickly over long-dated ones. The theory also contends that investors are compensated for higher default risk and price risk from changes in interest rates.

Pure Expectations Theory suggests that the shape of the yield curve is determined by interest rate expectations."

Segmented Markets Theory suggests that investors and borrowers have different needs that cause the demand and supply conditions to vary across different maturities; in other words, there is a segmented market for each term to maturity, which causes yields to vary among these maturity markets. It is also known as Market Segmentation Theory.

Three facts that the theory of the term structure of interest rates must explain
1. Interest rates on bonds of different maturities move together over time
2. When short term interest rates re low, yield curves are more likely to have an upward slope; when short term rates are high, yield curves are more likely to slope downward and be inverted
3. Yield curves almost always slope upward.

Three theories to explain the three stylized facts
1. Expectations theory
(expains 1,2 but not 3)

Expectations theory can explain

• why the term structure of interest rates changes at different times
• why interest rates on bonds with different maturities move together over time.
• why the yield curve tend to slope up when short term rates are low and slope down when short term rates are high (fact 2)
• BUT cannot explain why yield curves usually slope upward (fact 3)

2. Segmented markets theory
(only explains 3)

Bonds of different maturities are not substitutes at all.

• the interest rate for each bond with different maturity is determined by the demand for and supply of that bond
• Investors have preferences for bonds of one maturity over another.
• If investors generally prefer bonds with shorter maturities that have less interest rate risk, then this explains why the yield curve usually slopes upward (fact 3).
• Because it views the market for bonds with different maturities as completely segmented, there is no reason for a rise on a bond with one maturity to affect the interest rate on bonds wth another.

3. Liquidity premium theory
(combines the two theories to explain all 3 facts)

Assumes investors are risk adverse.

• The interest rate on a long term bond will equal an average of short term interest rates expected to occur over the life of the long term bond plus a liquidity premium that responds to supply and demand conditions for that bond
• Bonds of different maturities are partial (not perfect) substitutes.

Implications

The implication of the Pure Expectations Theory that expected returns for a holding period must be the same for bonds of different maturities depends on the assumption that instruments with different maturities are perfect substitutes.Under the expectations theory if market participants expect that future short-term rates will be higher than current short-term rates, the yield curve will slope upward.

This Segmented Market Theory's major conclusions are that yield curves are determined by supply and demand forces within each market/category of debt security maturities and that the yields for one category of maturities cannot be used to predict the yields for a different category of maturities.

Under the liquidity premium theory the shape of the yield curve depends on the expected pattern of future short-term rates and the size of the term premium at each maturity. According to the liquidity premium theory investors prefer shorter to longer maturities.