Question

why should bonds of differing maturity offer different yields? briefly explain the two plausible hypotheses related.

Answer 1

Bonds of different maturity will be offering different yields because there is different duration associated with them along with different types of market expectation of investors associated with them, and they are also exposing investors to various kinds of macro as well as micro risk.

Bonds which are having different maturity will be having different segments of buyers who will be expecting different returns, so that these bonds are offering different yields.

Two plausible hypothesis related are as follows-

A. Liquidity preference theory-investors are often demanding a risk premium for investing into long term bonds because these are for longer periods and the risks are also associated with them for longer periods.

These risk premium are known as liquidity premium.

Issuers often wants to issue long term bonds because they can lock in the rate which are to be paid on the long term bonds for the longer periods and it will help them to gain against market interest rate fluctuations and they will be willing to pay higher yields on long term bonds.

B. Theory of unbiased expectations-there will be a expectations about future rate of interest and expectations will be of higher rates because there will be expectation of upward sloping yield curve and that will be offering higher yield to maturity.