According to the liquidity premium theory of the term structure,
A) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a liquidity premium.
B) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of different maturities move together over time.
C) even with a positive liquidity premium, if future short-term interest rates are expected to fall significantly, then the yield curve will be downward-sloping.
D) all of the above.
E) only A and B of the above.

Question

Quizplus · Accepted Answer

The liquidity premium theory of the term structure posits that the interest rate on long-term bonds equals an average of short-term interest rates expected over the life of the long-term bonds plus a liquidity premium (A). It also acknowledges that investors may have preferences for bonds of certain maturities but suggests that interest rates on bonds of different maturities tend to move together over time (B). Additionally, it allows for the possibility of a downward-sloping yield curve if future short-term rates are expected to decrease significantly, despite a positive liquidity premium (C). Therefore, all of the statements (A, B, and C) are consistent with the liquidity premium theory, making (D) the correct answer.

According to the Liquidity Premium Theory of the Term Structure