According to the liquidity preference theory of the term structure of interest rates an increase in the yield on long term corporate bonds versus short term bonds could be due to _______.

Question

Quizplus · Accepted Answer

According to the liquidity preference theory, the yield on long-term bonds represents the expected future short-term rates and a premium for interest rate risk. An increase in expected interest rate volatility would increase the premium for interest rate risk, resulting in a higher yield on long-term bonds compared to short-term bonds. Therefore, D is the correct answer. A is incorrect because declining liquidity premiums would result in lower yields on long-term bonds. B is incorrect because the expectation of an upcoming recession would cause investors to prefer short-term bonds, driving down the yield on those bonds. C is incorrect because a decline in future inflation expectations would lower the yield on both short-term and long-term bonds.

According to the Liquidity Preference Theory of the Term Structure