Question

In: Economics

Compare the liquidity premium and the expectation hypothesis in their explanations of investor behavior. Which of...

Compare the liquidity premium and the expectation hypothesis in their explanations of investor behavior. Which of the two is more successful in explaining that behavior?

Solutions

Expert Solution

Liquidity premium theory asserts that the investors will always prefer short term securities compared to the long term securities as short term securities can be easily sold off.This theory focuses on how quickly an asset or securities should be sold so that its price will not get lowered.Accodity to this theory investors always like to avoid the uncertainties regarding the return from the securities thus investors will prefer short term bonds over the long term bonds as long term bonds has more uncertainty associated with it.Liquidity premium theory is explained with the help of yield curves.

In the case of expectation hypothesis theory investors will predict the future short term interest rates with the help of present long term interest rates.According to this theory the current long term interest rates will predict the future short term interest rates.Acvoding to these theory investors are able to forecast the future interest rates.

Comparing the above two theories liquidity premium theory is more reliable than the expectation hypothesis theory in explaining the investors behaviour.Expectation hypothesis has certain limitation to it.Investors are said to be risk averse and they always tries to reduce uncertainty.It is the liquidity premium theory that explains the risk averse nature of the investors.Acvording to expectations theory investors simply predict the future interest rates with the help of current interest rates.


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