Question

Which of the following theories can explain the stylized fact that interest rates on bonds of different maturities move together over time?

a) Expectations theory

b) Segmented markets theory

c) Liquidity premium theory

d) a) and c)

e) a) and b)

Which one of the following statement is true?

a) The expectation theory explains why the yield curve is upward slopping.

b) The segmented markets theory explains why the interest rates of bonds with different maturity dates move together over time.

c) The liquidity premium theory can explain the facts stated in (a) and (b), but it cannot explain why the yield curve is downward sloping when current short term interest rates are abnormally high.

d) None of above is true

Which one of the following statements is true?

a) The expectation theory explains why the yield curve is upward slopping.

b) The segmented markets theory explains why the interest rates of bonds with different maturity dates move together over time.

c) The liquidity premium theory can explain the facts stated in (a) and (b), but it cannot explain why the yield curve is downward sloping when current short term interest rates are abnormally high.

d) None of above is true

They are testing the same concepts, please explain how you get the answers in detailed

Answer 1

The liquidity premium theory predicts that interest rates of different maturities will move together because the long-term rates are essentially tied to the short-term rates.

1.The expectations theory also explain that , interest rates on bonds with different maturities move together over time.  An increase in short‐term interest rates tends to be higher in the future.  Therefore if short‐term rates rise, then people’s expectations regarding future interest rates will also rise.  Since here we consider long‐term rates to be the average of expected future short‐term rates, a rise in short‐term rates will also raise long‐term rates causing the two to move together over time.

The correct option is option D. Both expectations theory and liquidity premium theory explain that in the long run the long term rates are tied to the short term rates.

2. Since markets for different maturity bonds are segmented it cannot be the case that short‐term and long‐term bonds move together, and for the same reasoning it cannot explain why short‐term yields are more volatile than long‐ term yields. So, the market segmentations theory cannot explain that the interest rates of different maturities move together.

The expectations theory fails to explain why the yield curve is upward sloping because typically the expectations theory is more closely related to a flat yield curve since short term rates are just as likely to fall as they are to rise.

The market segmentations theory believes that the markets for different maturity bonds are segmented it cannot be the case that short‐term and long‐term bonds move together, it explains why the yield curve is upward sloping.   Empirically we know that investors prefer short‐term instruments since they are more liquid and also because they carry less risks.  This leads to a higher demand in the market for short‐term instruments which will cause higher prices and lower yield.  Hence the yield on long‐term bonds will be higher and this explains why the yield curve is upward sloping.

The liquidity preference theory explains why the yield curve is upward sloping because the long term bonds are risky and the investors will prefer to hold them only if they are compensated for the risk in the form of a higher premium.

Hence, in the liquidity theory holds that investors demand a premium to compensate them to interest rate exposure and the premium increases with maturity. By itself, the liquidity theory implies an upward sloping yield curve. Finally, since the risk premium increases with time to maturity, the liquidity premium theory tells us that the yield curve will normally slope upwards, only rarely will it lied flat or slope downwards

So, the correct option is option C.