Question

How did the portfolio balance lower the market term premia? Make sure to examine the underlying assumptions of the portfolio channel (preferred-habitat,…).                                                               

Answer 1

ANS: The portfolio balance channel assumes that the market for the longer term debt be segmented from rest of the market. The problems attached to the attached to the portfolio balance channel as applied to the empirical test of effectiveness of Federal open Market Committee (FOMC) for quantitative easing (QE).

With less duration risk to hold in the aggregate, market should require a  lower premium to hold the risk. Hence, the long term yield may decline due to :

• Riskiest assets are held by the investors or,
• Investor's portfolio are less risky.

The mechanism behind the Portfolio balance Channel, assuming imperfect substitutability has commonly being attributed two possible effects; Namely- The Preferred habitat & Duration of risk.

The Preferred habitat affects the Investor's preferences as to which type of asset to hold in terms of maturity.

The Portfolio Balance Approach is based on following assumptions :-

1. The Purchasing power parity which means the price to be constant, are not applicable here as the goods are assumed to be identical.
2. The Size of domestic market is so small, they don't have major foreign fluctuations.