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IAI Actuarial Core Principles · Actuarial Mathematics for Modelling · Term structure of interest rates

Which statement about the liquidity preference theory is correct?

Under liquidity preference theory investors require extra yield for holding longer-dated bonds because of their greater price risk, so forward rates exceed expected future spot rates. This tends to make the yield curve slope upward, though inversion is still possible.

  1. AForward rates equal expected future spot rates exactly
  2. BInvestors demand a premium for holding longer-dated bonds, so forward rates exceed expected future spot ratesCorrect
  3. CMarkets for different maturities are completely segmented and unrelated
  4. DYield curves can never be downward sloping
  5. Short-dated bonds carry a higher premium because of greater price volatility

Explanation

Liquidity preference says longer bonds are more price-volatile, so investors require a term premium. Forward rates therefore exceed expected spot rates. Option A describes pure expectations and C describes market segmentation. Inverted curves remain possible if falling rates are strongly expected.

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