IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates
According to the liquidity preference theory, the forward rate for a future period is:
Under liquidity preference theory, forward rates exceed expected future spot rates by a liquidity premium that generally increases with term, since investors prefer short-term bonds and demand compensation for lending longer.
- AAn unbiased predictor of the future spot rate
- BAlways below the expected future spot rate
- CEqual to the current spot rate in all periods
- DAbove the expected future spot rate by a premium that tends to rise with termCorrect
- Determined only by supply and demand within each maturity band
Explanation
Investors prefer short-term liquid bonds and need a premium to hold longer bonds, so forward rates exceed expected future spot rates by a premium typically increasing with term. The unbiased predictor view is pure expectations; the last option is market segmentation.
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