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CA Final · Advanced Financial Management · Security Valuation

Which statement about an upward-sloping yield curve is correct according to the liquidity preference theory?

According to liquidity preference theory, long-term rates contain a liquidity premium above the expected average of future short-term rates, because investors demand compensation for the greater price risk of longer maturities. So an upward slope can occur even without expected rate rises.

  1. ALong-term rates include a liquidity premium over the expected average of future short ratesCorrect
  2. BLong-term rates are always equal to expected future short rates
  3. CInvestors prefer long-term bonds and demand a discount for holding short-term bonds
  4. DThe curve slopes upward only if short rates are expected to rise

Explanation

Liquidity preference theory says investors need extra compensation for the greater price risk of long maturities, so forward rates exceed expected future spot rates by a liquidity premium. Hence the curve can slope upward even when short rates are expected to stay flat. The pure expectations view is the one tying slope solely to expected rates.

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