Assume that investors seek a lower liquidity premium from longer investments how does this force affect...

Assume that investors seek a lower liquidity premium from longer investments how does this force affect the term structure of interest rates, holding other factors constant.

Solutions

Expert Solution

The return on an investment consist of

Risk free rate + default risk premium + maturity risk premium + liquidity risk premium

If the investors expect the lower liquidity risk premium for long term investment then the required return for long term will be reduced keeping other things same, and holding other factors constant the term structure of the interest rate should be downward sloping because for short term investment the liquidity premium might be high or do not change but for long term liquidity premium the required rate reduces so the required rate would reduce and the tern structure of the interest rate should be downward sloping. However, in real world scenario, this might not happen because for long term investments the maturity risk premium is high comparative to short term so they might set off each other but if we are keeping the other risk premium constant and liquidity risk premium reduces for long term investment then the term structure of the interest rate would be downward sloping.

jeff jeffy answered 1 year ago

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