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ACCA Applied Skills · Financial Management · The valuation of debt and other financial assets

A company's treasurer observes that the yield curve for government bonds is upward sloping, with 1-year yields at 3% and 10-year yields at 5%. Which of the following is the explanation given by the liquidity preference theory for this shape, even if no rise in future short-term rates is expected?

Liquidity preference theory explains an upward-sloping curve by investors requiring a premium for lending long term, because longer maturities carry more price risk and less liquidity. Pure expectations and market segmentation theories offer different explanations, so only the premium for longer maturities fits.

  1. AInvestors demand a premium for lending long term, so longer maturities carry higher yieldsCorrect
  2. BBorrowers and lenders operate in separate maturity markets with independent supply and demand
  3. CLong-term yields are the exact geometric average of expected future short-term rates
  4. DInflation is always expected to be zero over the short term

Explanation

Liquidity preference theory says investors want compensation for tying up funds and bearing greater price risk on long-dated bonds, so long-term yields include a liquidity premium. The option about separate markets describes market segmentation theory. The option about averaging expected rates describes pure expectations theory, which has no premium.

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