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 expectations theory states that the shape of the yield curve, depends on the expectation of the people. if the people expect the short term rates to rise in the future, then the yield curve will be upward sloping. if the investors believe that the rates are going to fall, then the yield curve will be downward sloping.

the weakness of this theory is that it is purely based on expectations, investors have no preference between different bonds, of different maturities and interest rates.

b. in this theory, it is believed that the investors with a longer maturity bonds is exposed to higher risk, and thus they would be demanding a higher premium. the longer the time to maturity, the greater will be the yield premium. it is not purely based on expectations, it is based on the future expectations of the interest rates plus the yield premium. it is also called the biased theory of interest rates.

c.with an upward sloping yield curve, nothing can be said about the shape of the yield curve. it could be upward sloping, downward sloping or flat,but the yields which will continue to increase with maturity will make sure that the shape of the yield curve will be upward sloping. with a flat or declining yield curve it means that the short term interest rates are going to fall in the future, given that the yield premium will rise for the bonds with a longer maturity.