Which theory explains all three facts about the term structure?
A) expectations
B) segmented markets
C) preferential treatment
D) liquidity premium

Question

Quizplus · Accepted Answer

The liquidity premium theory explains all three facts about the term structure. It suggests that longer-term bonds have a higher yield than shorter-term bonds because investors demand compensation for holding longer-term bonds due to the risks associated with fluctuations in interest rates and inflation over a longer time period. This explains why the yield curve is typically upward sloping, why the yield on longer-term bonds is typically higher than the yield on shorter-term bonds, and why yield differentials across different maturities change over time.

Which Theory Explains All Three Facts About the Term Structure