The liquidity premium theory of the term structure
A) indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond.
B) assumes that bonds of different maturities are perfect substitutes.
C) suggests that markets for bonds of different maturities are completely separate because people have different preferences.
D) does none of the above.

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that long-term interest rates not only reflect investors' expectations about future short-term rates but also include a liquidity premium to compensate for the greater risk of holding longer-term bonds. It does not assume perfect substitutability of bonds of different maturities nor does it suggest that markets for different maturities are completely separate.

The Liquidity Premium Theory of the Term Structure