Question

Discuss the key features of the liquidity preference hypothesis of the term structure (no need to provide any formulas). Assuming the hypothesis is true, discuss what we can learn from the upward-sloping yield curve. Explain how your conclusions depend on the term premium.

Answer 1

        Theory of Liquidity Preference and an Upward Sloping Yield Curve

          According to the Theory of Liquidity Preference, the short-term interest rate in an economy is determined by the supply and demand for the most liquid asset in the economy – money. The concept, when extended to the bond market, gives a clear explanation for the upward sloping yield curve. Since investors strictly prefer liquidity, in order to persuade investors to buy long-term bonds over short-term bonds, the return offered by long-term bonds must be greater than the return offered by short-term bonds.

Liquidity premiums and bond yields

            Going by the idea that illiquid investments represent a greater risk for investors, the liquidity premium is one of the factors that explain differences in bond yields. A bond that matures in many years and that is issued by a little-known company without much financial data for investors to consult may be more difficult to sell. A bond with a shorter maturity issued by the same company would be a comparatively more liquid investment. Thus, investors who purchase that bond would require a lower liquidity premium.

Liquidity premium

Liquidity premium compensates investors for investing in securities with low liquidity. Liquidity refers to how easily an investment can be sold for cash. T-bills and stocks are considered to be highly liquid since they can usually be sold at any time at the prevailing market price. On the other hand, investments such as real estate or debt instruments are less liquid. It may take quite some time to sell real estate at the desired price. Some debt instruments must be held for a certain period of time before being sold.

Conclusion - Illiquid investments carry more risk than comparatively more liquid investments. This is because holding a single security for a long period of time exposes the investor to several risk factors, such as market volatility, potential default, economic downturns, interest rate fluctuations, risk-free rate fluctuations, etc. When investors tie up their money in a single security, they also incur the opportunity cost of investing in other assets that may outperform the illiquid investment. Due to the additional risks, an investor will demand a higher return, known as a liquidity premium.