Question

a. State the Pure (Unbiased) Expectations Theory.

b. How is the liquidity preference theory supposed to address the shortcomings of the pure expectations theory? (Hint: Time to maturity and liquidity premium)

c. Briefly discuss how the liquidity preference theory explains the shape of the yield curve. (HInt: Time to maturity and liquidity premium)

Answer 1

a) The pure or unbiased expectations theory states that expected future spot rates are equal to the forward rates calculated at present. Thus, long term interest rates are representations of the short term interest rates that investors expect to earn in future. It assumes that the returns or yields on higher or long term maturities correspond to the future realizable yield rates that are calculated from yields on short-term maturities. To put it simply, ‘future expected rates’ on long-term maturities are reflected through ‘forward rates’. For example, the yield from holding a one year bond today and the expected yield from holding another one year bond the next year, gives the same yield as investing in a two-year bond today.

b) The pure expectations theory might be simple and easy to understand, but it comes with grave shortcomings that are addressed correctly by the Liquidity Preference Theory. The shortcomings of pure expectations theory are as follows:

• It is assumed that investors have no preference regarding different maturity periods of different investments and the risks associated with them.
• To categorize the above point, the term of the maturity doesn’t matter. Same weight is given to the returns on a 30-year old bond and that on a 2-year old bond.
• Further, it doesn’t take into account the increasing and latent risk associated with long-term investments. It assumes that the risks associated with all bonds of the same type are uniform, irrespective of their maturity periods.

However, the above two point of ‘term’ and ‘liquidity premium’ mare noteworthy. In effect, as the term of bonds increases, the risks associated to holding those bonds grow. It is only natural that a higher risk implies a higher rate of return as a compensation for that risk. This higher rate of return incorporates the added risk associated with longer term bonds and calculates a ‘liquidity premium’ to adjust a rational agent for the added risk.

The Liquidity Preference Theory developed by Keynes correctly addresses these loopholes and states that longer term loans have an inbuilt liquidity premium in the interest rates. Therefore, the forward rates internalize or accommodate that premium and inflate or overstate the expected future one-period spot rates.

Pure Expectations Theory assumes that agents are indifferent to the terms of maturities because they do not consider long-term bonds to be riskier than short term ones. This would imply a maturity risk premium of zero whereas in reality, the maturity risk premium is positive, as is correctly addressed by the Liquidity Preference Theory. Thus Liquidity Preference Theory takes the Pure Expectations Theory a step forward by incorporating the added risk factor while maintaining all other postulates of the latter.

c) The yield curve is a measure of a return on the investment on a particular bond where the term of maturity is measured on the horizontal axis and the interest rate on the vertical axis. The Liquidity Preference Theory clearly states that long term yields are higher than short term yields due to an increased risk of holding a non-liquid asset for a longer period of time. This gives an upward sloping yield curve where long term investments should offer higher interest rates to make investors shift investment in favor of long-term and away from short term bonds. Even if interest rate expectations were same across different maturities, the yield curve would still be upward sloping due to the increased risk associated with longer terms of bonds. This is shown in figure 1.