Question #54
Reading: Reading 25 The Term Structure and Interest Rate Dynamics
PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf
Page: 22
Status: Unattempted
Correct Answer: B
Question
Assume that the interest rates in the future are not expected to differ from current spot rates. In such a case, the liquidity premium theory of the term structure of interest rates projects that the shape of the yield curve will be:
Answer Choices:
A. variable
B. upward sloping
C. downward sloping
Explanation
The liquidity theory holds that investors demand a premium to compensate them to
interest rate exposure and the premium increases with maturity. When the yield curve
under pure expectations is flat (i.e., interest rates in future are expected to be same as
current rates), addition of liquidity premium (which increases with maturity) would result
in an upward sloping yield curve.