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) “Pure Expectations” theory is a theory, which states that long-term interest rates in any economy substantially depend upon people’s expectations on short-term interest rates in future. On the basis of this theory, it is concluded that under unbiased expectations, a yield-curve with an upward slope reflects that market expects short-term interest rates to increase in future and a downward slope reflects that market expects short-term interest rates to decrease in future. The limitation of this theory is its ignorance towards investors’ preferences between different bonds available in the market and their risk expectations for bonds with different maturity.

b) “Liquidity Preference” theory is a theory which states that investors require a higher interest rate or yield on securities with longer maturity period, since longer maturity period securities carry higher risk of default. Hence, this theory incorporates investors’ preferences related to maturity and liquidity, which is ignored in “Pure Expectations” theory.

c)As per “Liquidity Preference” theory, when a yield curve has an upward slope, we really can’t conclude anything concrete as there are multiple factors that may have a yield curve sloping upwards. However, when a yield curve has a flat or declining slope, it means that market expects short-term interest rates in future to fall from the current interest rates levels.