Friday, September 18, 2009

The Liquidity Premium View of The Yield Curve

the strong assumption underlying the unbiased expectations theory coupled with the real-world behavior of investors have caused many financial analysts to question the theory‘s veracity. securities dealers and analysts who trade actively in the financial markets frequently argue that other factors decides rate expectations also exert a significant impact on the character of the yield curve.
For example, in recent years most yield curves have sloped upward. Is there a built-in bias toward positively sloped yield curves due to factors other than interest-rate expectations? The liquidity premium view of the yield curve suggests that such a bias exists.
Longer-term securities tend to have more volatile market prices tan short-term securities. Therefore, the investor faces greater risk of capital loss when buying long-term financial instruments. To overcome this risk, it is argued, investors must be paid an extra return in the form of an interest-rate premium to encourage them to purchase long-term securities. This rate premium for the surrender of liquidity on longer-term issues, if it exists, would tend to give yield curves a bias toward an upward slope.
Why then do some yield curves slope downward? In such instances, expectations of declining interest rates plus other factors simply overcome the liquidity premium effect. The liquidity premium view does not preclude the important role of interest-rate expectations in influencing the shape of the yield curve. Even though expectations may be the dominant factor influencing the yield curve, however, other factors such as liquidity play an important role as well.
Moreover, the liquidity argument may help explain why yield curves tend to "flatten out" at the longest maturities. There are obvious differences in liquidity between a 1-year and 10-year bond, but it is not clear that major differences in liquidity exist between a 10-year bond and a 20-year bond, for example. Therefore, the size of the required liquidity premium paid to long-term investors may decrease for securities of the longest maturities

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