| The Motley Fool, Iowa State University: Liquid Premium Theory, "Suppose one-year interest rate over the next five years are 5%, 6%, 7%, 8%, 9%, liquidity premiums for one to five-year bonds are 0%, 0.25%, 0.5%, 0.75%, 1.0%, Then, interest rate on the two-year bond: (5% + 6%)/2 + 0.25% = 5.75%, Interest rate on the five-year bond: (5% + 6% + 7% + 8% + 9%)/5 + 1.0% = 8%, Interest rates on one to five-year bonds: 5%, 5.75%, 6.5%, 7.25% and 8%. Generally speaking, markets with many participants are highly liquid relative to markets with fewer participants. 1.2.2 The Liquidity Premium Theory • Liquidity premium theory asserts that bondholders greatly prefer to hold short-term bonds rather than long-term bonds. C) decline moderately in the future. (Round your response to the nearest whole number). A theory stating that forward rates do not accurately predict future spot rates because forward rates are more liquid and therefore include a liquidity premium. Invest for maximum results with a minimum of risk. Although illiquidity is a risk itself, subsumed under the liquidity premium theory are the other risks associated with long-term bonds: notably interest rate risk and inflation risk. 1. Biased Expectations Theory: A theory that the future value of interest rates is equal to the summation of market expectations. The liquidity premium theory of the term structure proposes: A. it is the relative supply and demand of securities in the various maturity ranges that determines yields. Short-term yields are more volatile than long-term yields. The inverted yield curve can also predict recessions, since this curve has preceded all 9 recessions in the United States since 1955. Jupiterimages, Creatas Images/Creatas/Getty Images. The theory also contends that investors are compensated for higher default risk and price risk from changes in interest rates. Information is provided 'as is' and solely for education, not for trading purposes or professional advice. According to the liquidity premium theory of the term structure, asked Jan 6 in Business by Fenimore A) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a liquidity premium. In fact, LPT is a synthesis of both ideas on bonds, maturities and their respective effects on yields. A bond's yield can theoretically be divided into a risk-free yield and the risk premium. Preferred Habitat Theory (PHT) is an extension of the market segmentation theory, in that it posits that lenders and borrowers will seek different maturities other than their preferred or usual maturities (their usual habitat) if the yield differential is favorable enough to them. On the other hand, borrowers generally want to lock in low rates, so the supply for long-term bonds will increase. Logos for Yahoo, MSN, MarketWatch, Nasdaq, Forbes, Investors.com, and Morningstar. Therefore, this theory implies that long-term bonds should offer higher yields. The yield curve shows how yield changes with time to maturity — it is a graphical representation of the term structure of interest rates. Liquidity Theory of the Term Structure. This could only be explained by the expectations hypothesis if the future interest rate was expected to continually rise, which isn't plausible nor has it been observed, except in certain brief periods. The types of yield curve shifts that regularly occur include parallel shifts, flattening shifts, twisted shifts, and shifts with humpedness. Naturally, increased risks will lower demand for those bonds, thus increasing their yield. However, the yield curve isnât always upward-sloping: sometimes it zigzags, flattens out or even becomes inverted. Liquidity theory of the term structure. Therefore, the yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little, and so the liquidity premium theory of the term structure of interest rates explains the generally upward sloping yield curve for bonds of different maturities. The liquidity premium theory focuses on the question of how quickly an asset can be sold in the market without lowering its stated price. The risk premium is the liquidity premium that increases with the term of the bond. Inflation risk reduces the real return of the bond. If the economy is expanding, then the yield spread narrows, since an expanding economy indicates less risk for bond issuers, so bondholders sell safer, lower-yielding government bonds for higher-yielding corporate bonds. Suppose that the yield curve for U.S. Treasuries offers the following yields: 2.5 percent for three-month bills, 2.75 percent for one-year notes, 3.25 percent for five-year bonds, 4.5 percent for 10-year bonds and 6.25 percent for 30-year bonds. For instance, suppose the 2-year bond paid only 4.5% with the expected interest rates remaining the same. The liquidity premium theory is an offshoot of the pure expectations theory. What Is a Long-Term Maturity Treasury Note? Besides liquidity, there are 2 other risks with holding bonds that increases with the term of the bond: inflation risk and interest rate risk. The most popular version of the yield curve tracks U.S. Treasury debt from three-month Treasury bills through 30-year Treasury bonds. ... forward rates will not be a pure estimate of the market's expectations of future interest rates because they embody a liquidity premium. The risk-free yield is simply the yield calculated by the formula for the expectation hypothesis. Short-term interest rates to stay near their current levels. The term structure of interest rates is the variation of the yield of bonds with similar risk profiles with the terms of those bonds. All articles on this site were written by. Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. There are several versions of the expectations hypothesis, but essentially, the expectations hypothesis (aka Pure Expectation Theory, Unbiased Expectations Theory) states that different term bonds can be viewed as a series of 1-period bonds, with yields of each period bond equal to the expected short-term interest rate for that period. Hence, a lower demand and a higher supply will cause long-term bond prices to fall, thereby increasing their yield. This article has already explained some of the hypotheses or theories to account for the yield curve and its changes, but regardless of the veracity of those explanations, the yield curve does shift in ways that are hard to predict, which lowers the effectiveness of bond strategies and makes it more difficult to analyze interest rate risk. On the other hand, borrowers prefer the long-term to invest in capital assets. Although yield shifts are difficult to predict and to explain, they can be described. The general pattern is that shorter maturities have lower interest rates than longer maturities. The inverted yield curve often results when short-term interest rates are higher than historical averages, since there is a greater expectation that rates will decline, so long term bond issuers would be reluctant to issue bonds with higher rates when the expectation is that lower rates will prevail in the near future. 51) The liquidity premium theory of the term structure A) indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond. Each week, Zack's e-newsletter will address topics such as retirement, savings, loans, mortgages, tax and investment strategies, and more. Interest rate risk is the risk that bond prices will drop if interest rates rise, since there is an inverse relationship between bond prices and interest rates. Generally, the debt market is divided into 3 major categories in regard to maturities: short-term, intermediate-term, and long-term. 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