Question

Question 3 [Note: Keep your answer as concise as possible.]

a) How does the Liquidity Premium Theory of the term structure of interest rates differ from the pure expectations theory?

b) Use the Liquidity Premium Theory to explain the following statement: “Although expecting increases in future interest rates could result in an upward-sloping yield curve, an upward-sloping yield curve does not necessarily imply the expectation of higher future interest rates.”

Answer 1

a)

Liquidity Premium Theory and Pure Expectation Theory are part of the term structure theory of interest rate.

Pure expectation theory:

Under pure expectation theory, we hypothesize that it is the investors'expectations that determine the shape of interest rate term structure. The theory suggests that forward rates are a function of future spot rates and that every maturity strategy has the same expected return i.e., long term interest rate equal the mean of future expected short term rates. For eg., an investor will earn the same expected return by investing in 5 yr bond or by investing in 3 yr bond and then a 2 yr bond after the 3 yr bond matures. It works on the principle of risk neutrality.

Liquidity Premium Theory:

The liquidity premium theory addresses the shortcomings of pure expectations theory by proposing that forward rates reflect investors' expectations of future spot rates plus a liquidity premium to compensate investors for exposure to interest rate risk. Also, the theory suggests that the liquidity premium is positively related to maturity: a 25 yr bond should have a larger liquidity premium than a 5yr bond. Thus it states that forward rates are biased estimates of market expectations.

b)

The liquidity premium theory states that forward rates include a liquidity premium to compensate investors for exposure to interest rate risk.

A positive sloping yield curve may indicate either

1) The market expects the future interest rate to rise or

2) rates are expected to remain constant (or even fall), but the addition of liquidity premium results in a positive slope.

A downward-sloping yield curve indicates steeply falling short term rates. The size of liquidity premiums may be larger during greater economic certainty when risk aversion among investors is high.