If the yield curve slope is flat for short maturities and then slopes steeply upward 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 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)constant short-term interest rates in the near future and a decline further out in the future.

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, investors demand a higher return for holding longer-term bonds, as they are more risky due to the uncertainty of future interest rates. Therefore, a steep upward slope in longer maturities indicates that investors expect a rise in interest rates in the future. The mild preference for shorter-term bonds suggests that investors believe short-term interest rates will decline in the near future. Therefore, the flat slope for short maturities and upward slope for longer maturities suggest a decline in short-term interest rates in the near future and a rise further out in the future, making option C the best choice.

If the Yield Curve Slope Is Flat for Short Maturities