37. How does the liquidity premium theory of the term structure of interest rate

Question

37. How does the liquidity premium theory of the term structure of interest rates differ from the unbiased expectations theory? In a normal economic environment, that is, an upward-sloping yield curve, what is the relationship of liquidity premiums for successive years into the future? Why? 37. How does the liquidity premium theory of the term structure of interest rates differ from the unbiased expectations theory? In a normal economic environment, that is, an upward-sloping yield curve, what is the relationship of liquidity premiums for successive years into the future? Why?

Explanation / Answer

The unbiased expectations theory involves the interest rates of the secuirties and other investments which involves long term rates and these long term rates are expected rates considered to be earned in the nearby future on the investment.

These long term rates are average of current as well as expected short term rates which are more or less predictible and doesnot involve risk thereby termed as unbiased such as treasury bonds etc, where the returns are expected and is not affected by the market growth and opportunities.

Whereas, Liquidity premium theory not only involves long term rates which are an average of current and short term rates but it also involves market risk premium therefore the market risk are attached to such interest rates. They grow if the economy grows and in nearby future they can give you a higher return resultant the growth of the market. The premium increases at the maturity of the security.

This is the factor that in a normal economic environment there is an upward sloping yield curve in the Liquidity premiums theory as the interest rate increases and also the premium of the security increase till it reaches to the maturity period.

The relationship of the Liquidity premiums for the successive years with the growth of economy in the future where the economic environment is normal and growth is stable or increase is upward sloping as the yield premium will increase fast enough to continue to produce an upward curve with no concerns about short-term interest rates and Because of the longer maturity, there is a greater price volatility associated with these securities.

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