Suppose that interest rates are expected to remain unchanged over the next few years. However, there is a risk premium for longer-term bonds. According to the liquidity premium theory, the yield curve should be:
A) upward sloping and very steep.
B) upward sloping and relatively flat.
C) inverted.
D) vertical.

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, longer-term bonds have a higher risk premium due to greater uncertainty and greater price risk. With interest rates expected to remain unchanged, the yield curve should slope upward, but not as steeply as in option A. Therefore, option B (upward sloping and relatively flat) best fits this scenario. Option C (inverted) would suggest that interest rates are expected to decline in the future, which is not the case in this scenario. Option D (vertical) would suggest that there is no difference in risk premium between short-term and long-term bonds, which is inconsistent with the liquidity premium theory.

Suppose That Interest Rates Are Expected to Remain Unchanged Over