Question

1. Suppose that the 10 year yield, calculated under Unbaised Expectations Theory, is 7%. What do you think the same rate would be under Liquidity Preference Theory if the Yield Curve is normal? Explain why, explicitly to take full credits.

Answer 1

Unbaised Expectations Theory,

The theory uses long-term rates, typically from government bonds, to forecast the rate for short-term bonds. In theory, long-term rates can be used to indicate where rates of short-term bonds will trade in the future. The theory suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today.

Liquidity Premium Theory

Liquidity refers to how quickly an asset can be sold without lowering its price. Generally speaking, markets with many participants are highly liquid relative to markets with fewer participants. The liquidity premium theory states that bond investors prefer highly liquid, short-dated securities that can be sold quickly over long-dated ones. The theory also contends that investors are compensated for higher default risk and price risk from changes in interest rates.

The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape, and it's sometimes referred to as the "positive yield curve. An upward-sloping yield curve supports the liquidity premium theory. Suppose that the yield curve for U.S. Treasuries offers the following yields: 2.5 percent for three-month bills, 3 percent for one-year notes, 5 percent for five-year bonds,7 percent for 10-year bonds . The rising yield curve is consistent with the liquidity premium theory, with the U.S. government paying investors progressively higher rates for debt with longer maturities.

in liquidity Preference Theory it will not be same rate because it gives more preferance to the liquid short trem assests and as liquidity decreases, premium increases . but calculation of 7% is made on the basis of Unbaised Expectations Theory The theory uses long-term rates, typically from government bonds, to forecast the rate for short-term bonds. so the basis of calculation of interest rate is different in bothe the theory. so rate can not be same.