Which theory of term structure states that long-term rates are equal to the geometric average of current and expected short-term rates plus a risk premium that increases with the maturity of the security?
A)The unbiased expectations theory.
B)The liquidity premium theory.
C)The loanable funds theory.
D)The market segmentation theory.
E)None of the options.

Question

Quizplus · Accepted Answer

This theory is called the liquidity premium theory. It suggests that the shape of the yield curve is determined by the market’s perception of the risk associated with holding long-term bonds. According to this theory, long-term rates are equal to the geometric average of current and expected short-term rates plus a risk premium that increases with the maturity of the security.

Which Theory of Term Structure States That Long-Term Rates Are