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ACCA Applied Skills · Financial Management · Causes of exchange rate differences and interest rate fluctuations

Under the liquidity preference theory of the term structure of interest rates, why does the yield curve normally slope upwards?

The yield curve normally slopes upwards under liquidity preference theory because investors prefer liquidity and regard long-term lending as riskier, so they demand a higher yield, a liquidity premium, to lend for longer periods.

  1. AInvestors demand a premium for lending long term because they prefer liquidity and face greater risk of price changesCorrect
  2. BGovernments always set long-term rates above short-term rates
  3. CShort-term borrowers pay more because they borrow in larger amounts
  4. DInflation is always higher in the long term than the short term

Explanation

Liquidity preference theory says investors prefer to lend short term and will lend long term only if compensated by a higher yield. The premium rises with maturity, so the curve normally slopes upwards. The other options state causes that the theory does not rely on.

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