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

The liquidity premium theory states that investors require a premium for holding longer-term bonds, to compensate for the additional risk and uncertainty associated with holding these bonds over a longer period of time. Therefore, the yield curve should be upward sloping, indicating that longer-term bonds have higher yields than short-term bonds. However, if interest rates are expected to remain unchanged, the slope of the yield curve should be relatively flat. Therefore, choice B is the best answer.

Suppose That Interest Rates Are Expected to Remain Unchanged Over