Question #21

Reading: Reading 25 The Term Structure and Interest Rate Dynamics

PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf

Page: 8

Status: Correct

Correct Answer: B

Part of Context Group: Q21-23 First in Group
Shared Context
- Following Wallace's first lecture he asks the trainees which of the following explains an upward sloping yield curve according to the (unbiased) pure expectations theory of the term structure of interest rates? A) There is greater demand for short-term securities than for long-term securities. B) There is a risk premium associated with more distant maturities. C) The market expects short-term rates to rise through the relevant future.
Question
Wallace now poses a similar question regarding the liquidity preference theory. Which of the following could explain an upward sloping yield curve according to the liquidity preference theory of the term structure of interest rates?
Answer Choices:
A. There is a risk premium associated with more distant maturities
B. The market expects short-term rates to rise through the relevant future
C. There is greater demand for short-term securities than for long-term securities
Explanation
According to the liquidity preference theory, the pure expectations theory applies but is modified for a risk or term premium. The longer the maturity, the greater the risk of price fluctuation to the investor. Short-term rates to rise through the relevant future could explain an upward sloping yield curve according to the pure expectations theory. Greater demand for short-term securities than for long-term securities could explain an upward sloping yield curve according to the market segmentation theory. The market segmentation theory implies that the rate of interest for a particular maturity is determined solely by demand and supply for that maturity, with no reference to conditions for other maturities.
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