If liquidity influences the yield curve, but is not considered when deriving the forward interest rate, the forward interest rate ____ the market's expectation of the future interest rate.
A)overestimates
B)accurately estimates
C)underestimates
D)is an unbiased forecast of (it has an equal chance of overestimating or underestimating)

Question

Quizplus · Accepted Answer

Liquidity preferences can cause the yield curve to reflect higher interest rates for longer maturities, not solely due to expectations of higher future rates but also due to the demand for premium for longer-term investments. If liquidity is not considered when deriving the forward interest rate from the current yield curve, the forward rate may overestimate the market's expectation of future interest rates, as it includes a liquidity premium that is not directly related to expectations of future rate movements.

If Liquidity Influences the Yield Curve, but Is Not Considered