If the yield curve is flat for short maturities and then slopes downward for longer maturities,the liquidity premium theory (assuming a mild preference for shorter-term bonds)indicates that the market is predicting
A)a rise in short-term interest rates in the near future and a decline further out in the future.
B)constant short-term interest rates in the near future and a decline further out in the future.
C)a decline in short-term interest rates in the near future and a rise further out in the future.
D)a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that longer-term interest rates incorporate a premium for holding longer-term bonds, due to their greater risk compared to short-term bonds. A flat curve for short maturities transitioning to a downward slope for longer maturities implies that investors expect short-term rates to remain relatively stable but anticipate a more significant decline in interest rates in the future. This expectation of a steeper decline further out is consistent with the market's anticipation of lower future rates, aligning with choice D.

If the Yield Curve Is Flat for Short Maturities and Then