According to the liquidity premium theory of the term structure,a downward sloping yield curve indicates that short-term interest rates are expected to
A)rise in the future.
B)remain unchanged in the future.
C)decline moderately in the future.
D)decline sharply in the future.

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that long-term interest rates incorporate a premium for holding longer-term securities, which are less liquid and carry more risk than short-term securities. A downward sloping yield curve, according to this theory, indicates that investors expect short-term interest rates to decline sharply in the future. This expectation is because investors demand a premium to hold longer-term securities, which would only make sense if they anticipate lower returns on short-term investments in the future.

According to the Liquidity Premium Theory of the Term Structure,a