According to the liquidity premium theory of the term structure, a steeply upward sloping yield curve indicates that short-term interest rates are expected to
a. rise in the future.
b. remain unchanged in the future.
c. decline moderately in the future.
d. decline sharply in the future.
The correct answer and explanation is :
Correct Answer: a. rise in the future.
Explanation:
The liquidity premium theory of the term structure of interest rates builds on the expectations theory but incorporates an important additional concept: investors require a premium for holding longer-term bonds, which are considered riskier due to their greater price volatility and sensitivity to interest rate changes.
Under this theory, the interest rate on a long-term bond equals the average of current and expected future short-term interest rates plus a liquidity premium. This premium increases with the term to maturity, as compensation for the increased risk of holding long-term securities.
A steeply upward sloping yield curve, where long-term interest rates are significantly higher than short-term rates, implies two key things:
- Investors expect short-term interest rates to rise in the future.
- There is a liquidity premium that adds to the yield of longer-term bonds.
So, even if the average expected future short-term rates were only modestly higher than current rates, the liquidity premium causes long-term yields to be even higher, steepening the curve. If the yield curve is very steep, this suggests that investors not only expect rising short-term rates but also demand a sizable premium to compensate for the risk of holding long-term bonds.
In this way, the liquidity premium theory helps explain why yield curves are usually upward sloping: investors generally require compensation for the additional risks of longer maturities. However, when the curve is steep, it’s a strong signal that the market expects future short-term interest rates to increase significantly.
Thus, according to the liquidity premium theory, a steeply upward sloping yield curve indicates that short-term interest rates are expected to rise in the future — making option (a) the correct answer.