Question

how does the expectations and liquidity preference theories complicate the interpretation of the message of the yield curve?

Answer 1

Expectations and liquidity preference theory are applicable in case of determination of the long-term yield of debt securities and they will be advocating that there should be a higher expectation of high rate of interest on long term bonds.

Expectation theory will advocate that there will be an expectation of high rate of interest for investment into the longer term was because investors are exposed to the uncertainties and the liquidity theory will also advocate that the investor will be wanting to be compensated for lack of liquidity in the long term bonds and hence they will be demanding a higher rate of interest.

There are complications in interpretation of the message as liquidity theory will only considered the liquidity of the bonds whereas it would not be considering the other factors because bonds are not just based upon the liquidity but they are also based upon a lot of factors and the expectation on these bonds will be different due to Expectations theory like when a short term Bond will be having a bad credit rating, whereas the long term bonds will be having a higher credit rating than expectation will be higher for the short term Bond and it can even be complicated for the Liquidity concept because they are highly theoretical theories and they are not really applicable in the real world much.