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ACCA Applied Skills · Financial Management · The nature and role of financial markets and institutions

A company observes that the yield curve for government bonds is steeply upward sloping, with 1-year yields at 2% and 10-year yields at 6%. Under the liquidity preference theory, which statement best explains why long-term yields are higher than short-term yields, even if short-term rates are not expected to rise?

Under liquidity preference theory, long-term yields exceed short-term yields because investors demand a premium for the greater price risk and lower liquidity of longer-dated securities. This premium exists even if short-term rates are not expected to rise, so the curve slopes upward.

  1. AInvestors require a premium for the greater price risk and reduced liquidity of holding longer-dated securitiesCorrect
  2. BInvestors prefer long-dated securities because they are easier to sell quickly than short-dated ones
  3. CBorrowers wish to borrow only for short periods so demand for short-dated funds is lower, pushing short-term yields down
  4. DGovernments issue fewer long-dated bonds, so their prices are always lower and yields higher

Explanation

Liquidity preference theory says investors prefer liquidity and lower price sensitivity, so they demand extra yield (a liquidity premium) to hold longer-dated securities. This applies even when no rise in short rates is expected, which distinguishes it from pure expectations theory. The option claiming long-dated bonds are easier to sell reverses the theory.

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