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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

In a normal, upward-sloping government bond yield curve, which statement is consistent with the liquidity preference theory of the term structure?

Liquidity preference theory says long bonds carry a term premium to compensate investors for greater price risk and lower liquidity. Hence the yield curve tends to slope upward even when short rates are expected to remain unchanged.

  1. ALonger-maturity bonds offer a term premium because investors demand compensation for greater price risk and reduced liquidityCorrect
  2. BLong-term yields equal the average of expected future short rates with no additional premium
  3. CYields at each maturity are set only by supply and demand within that maturity segment
  4. DInvestors strictly prefer long-dated bonds and so accept lower yields on them
  5. Short-term yields are always higher than long-term yields because of reinvestment risk

Explanation

Liquidity preference theory says investors prefer shorter, more liquid securities and need a term premium to hold longer bonds. This makes the curve slope upward even if short rates are expected to stay flat. The pure expectations theory has no premium, so option 1 is wrong.

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