The liquidity premium theory of the term structure of interest rates:
A)assumes that investors will hold long-term maturity assets if there is a sufficient premium to compensate for the uncertainty of the long term.
B)assumes that long-term interest rates are an arithmetic average of short-term rates plus a liquidity premium.
C)recognises that forward rates are perfect predictors of future interest rates.
D)assumes that risk premiums increase uniformly with maturity.

Question

Quizplus · Accepted Answer

The liquidity premium theory postulates that investors will hold long-term maturity assets if there is a sufficient premium to compensate for the uncertainty of the long term. This theory argues that long-term interest rates comprise both the expected future short-term rate and a premium to compensate for the increased risk of holding long-term debt instruments, that is, liquidity premium. Therefore, the theory suggests that the yield curve is determined by expected future short-term rates and additional returns demanded by investors to hold long-term debt instruments due to their uncertain nature.

The Liquidity Premium Theory of the Term Structure of Interest