Liquidity Preference Theory Yield Curve

liquidity preference

Flat or downward sloping yield curves are mainly caused by declining future short-term interest rates. The local expectations form of the pure expectations theory recognizes that in the long term interest rate and reinvestment risks are important. In the short term these risks are ignored and investors are assumed to be indifferent between different instruments. For example, it states that the two alternative strategies mentioned above may not yield the same results, but if the investment horizon is reasonably short (i.e., 6-month), the choice of investment instrument is largely irrelevant.

upward sloping

The swap curve provides another measure of the time value of money. Or a triangular arbitrage role for the cross-rate between JPY/USD and AUD/USD. In the following section, we investigate how much the latter role contributes to an explanation of the microstructural behavior of traders in the JPY/AUD market.

Liquidity Preference Example¶

When the prices of long-term debt are bid down enough, then the flat yield curve changes to an inverted or descending yield curve. This theory introduces the concept of a risk or liquidity premium to our equation for predicting future rates. Thus, even if the interest rate expectations were the same across the entire spectrum of maturities, the yield curve would still be sloping upwards due to the inherent risk of acquiring a debt instrument at a longer maturity. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity.

This sounds very similar to the habitat theory discussed below, but there is an important difference between these two. The preferred habitat theory argues that investors will shift out of their preferred maturity sectors if they are given a sufficient high maturity premium. In contrast, the market segmentation theory asserts that investors will always stick to their preferred maturity sectors.

The Current Yield Curve Inversion, Explained – MonetaryMetals … – Advisor Perspectives

The Current Yield Curve Inversion, Explained – MonetaryMetals ….

Posted: Tue, 20 Dec 2022 08:00:00 GMT [source]

The preferred habitat theory argues that, if there are imbalances between supply and demand at a particular maturity, then investors are willing to shift habitat in exchange for a premium. The only difference with the segmented market theory is that lenders and borrowers are willing to change maturity in exchange for a premium. Segmented market theory argues that the term structure is not determined by either liquidity or expected spot rates. Instead, the shape of the yield curve is solely determined by the preference of borrowers and lenders. The yield curve at any maturity simply depends on the supply and demand for loans at that maturity.

How Does Liquidity Preference Theory Work?

For example, if the 1-year forward 2 years from today is 6%, the pure expectations theory states that the market expects a 6% 1-year rate in two years. In other words, bond investors generally prefer short-term bonds and will not opt for a long-term debt instrument over a short-term bond with the same interest rate. Investors will be willing to purchase a bond of a different maturity only if they earn a higher yield for investing outside their preferred habitat, that is, preferred maturity space.

It suggests that the term structure of interest rates is based on investor expectations about future rates of inflation and corresponding future interest rates, assuming that the real interest rate is the same for all maturities. An inverted yield curve is an unusual state in which longer-term bonds have a lower yield than short-term debt instruments. Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates. The theory suggests that an investor earns the same interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today. Income rather than the interest rate primarily influence the transaction and precautionary motives. Therefore, as income increases, cash reserve for the transaction and precautionary motives increase and vice versa.

Preferred Habitat Theory

The liquidity-preference theory cannot explain the occurrence of different rates in different credit market segments because all units of money are perfectly interchangeable. The vertical line, QM, represents the money supply, and the horizontal line, L, represents the total demand for money. Both curves meet at E2, where the equilibrium interest rate, OR, is determined.

term interest rate

For instance, when interest rates rise, the demand for short-term bonds increases faster than the demand for long-term bonds, flattening the yield curve. Such was the case in 2006, when T-bills were paying the same high rate as 30-year Treasury bonds. A bond’s yield can theoretically be divided into a risk-free yield and the risk premium. The risk-free yield is simply the yield calculated by the formula for the expectation hypothesis.

The expectations theory

Proponents of the biased expectations theory argue that the shape of the yield curve is influenced by systematic factors other than the market’s current expectations of future interest rates. In other words, the yield curve is shaped from market expectations about future rates and also from other factors that influence investors’ preferences over bonds with different maturities. Liquidity preference theory is essentially an improved version of the pure expectations theory. It maintains the former’s postulate that different maturities are substitutable, but adds that they are only partially so. According to Keynes General Theory, the short-term interest rate is determined by the supply and demand for money. Holding money is the opportunity cost of not investing that money in short-term bonds.

equilibrium interest rate

In Man, Economy, and State , Murray Rothbard argues that the liquidity preference theory of interest suffers from a fallacy of mutual determination. Keynes alleges that the rate of interest is determined by liquidity preference. In practice, however, Keynes treats the rate of interest as determining liquidity preference.


From equities, fixed income to derivatives, the CMSA certification bridges the gap from where you are now to where you want to be — a world-class capital markets analyst. He also said that money is the most liquid asset and the more quickly an asset can be converted into cash, the more liquid it is. Section 8 builds on the factor model and describes how to manage the risk of changing rates over different maturities.

  • Under this Pure Expectations Theory, we say that the Yield Curve has no a priori upward or downward (negative; inverted) bias.
  • Suppose that some events have no effect on expected interest rates, but raises uncertainty about rates.
  • Consequently, there is no a priori equilibrium in capitalist economies driven by the accumulation of money, power, status, and self-esteem.
  • Testing the predictions of the trilemma paradigm remains work in progress, as there is no unique way to define and measure the degree of exchange-rate flexibility, monetary autonomy, and financial integration.

You should be able to draw these two curves (i.e., both the YTM Curve and Spot Curve, given the calculated values of “x” and “y”) on a chart, with the yield on the vertical and the years-to-maturity on the horizontal. Note that after the first year, the two curves diverge, with the Spot Curve, in this example, rising above the Yield Curve, pulling it upward. Of course, if the Yield Curve is inverted , the spot curve would be lower that it and we would conclude that future, short-term rate expectations are decreasing.

Explain why prices of risky bonds may decline when economic conditions weaken. Explain the relationship between the domestic interest rate, the foreign interest rate, the time to maturity, and the volatility. Explain why yields to maturity and bond prices move in opposite directions. Here we shall present four theories that attempt to explain why the Yield Curve may take on one or another slope – upward , flat, or downward . We cannot say that any one theory is more correct than the other, nor can we necessarily reconcile one theory in terms of another.

  • The desire for liquidity isn’t the only element that influences interest rates.
  • Simply put, interest rates directly indicate the price of the money.
  • When financial markets are complete, and preferences are identical, all countries experience a liquidity trap simultaneously, because natural real interest rates are in that case equated across countries.
  • Keynesian economics comprise a theory of total spending in the economy and its effects on output and inflation, as developed by John Maynard Keynes.

Thus, investors require a liquidity premium as a reward for lending long-term bonds. Liquidity Preference Theory is a theory that suggests that investors demand higher interest rates or additional premiums for medium or long-term maturities and investments. According to this theory, the risk increases with maturity. In such a situation, investors should aim for higher interest rates because short-term investments are more liquid than medium or long-term investments. Simply put, interest rates directly indicate the price of the money.

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