The Risk and Term Structure of Interest Rates - Term Structure of Interest Rates - Liquidity Premium and Preferred Habitat Theories
4 important questions on The Risk and Term Structure of Interest Rates - Term Structure of Interest Rates - Liquidity Premium and Preferred Habitat Theories
What is the liquidity Premium Theory?
What are the key assumptions of the liquidity premium theory?
- Bonds of different maturities are partial substitutes. Investors tend to prefer shorter-term bonds, because bear less interest rate risk
- Investors must be offered a positive liquidity premium to hold longer term bonds
What is the preferred habitat theory?
• They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return.
• Investors are likely to prefer short-term bonds over longer-term bonds.
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What does the preferred habitat theory show?
Shows that
1. Interest rates on different maturity bonds move together over time (exp theory)
2. Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; (explained by the liquidity premium term in the first case and by a low expected average in the second case (expl theo))
3. Yield curves typically slope upward (explained by a larger liquidity premium as the term to maturity lengthens)
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