The liquidity premium theory holds that investors
A) always choose the bond with the highest expected return, regardless of maturity.
B) require a term premium to compensate them for investing in a less preferred maturity.
C) view bonds of different maturities as perfect substitutes.
D) view bonds of different maturities as completely unsubstitutable.

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that investors require a term premium to compensate them for investing in a less preferred maturity. This is because investments in longer-term bonds expose investors to greater interest rate risk and inflation risk. Therefore, to attract investors to invest in longer-term bonds, issuers must offer a higher expected return, which is represented by the term premium.

The Liquidity Premium Theory Holds That Investors