Liquidity Preference Theory

This is the third part of our article series on interest rate theories. Read the first part about forex and the yield curve here.

In the previous chapter, we noted that the pure expectations theory (PET) cannot explain why short-term yields are typically lower than longer-term yields most of the time. Since PET assumes rates across the maturity spectrum to be equivalent in quality and function, we’d expect a homogenous distribution of both downward and upward sloping yield curves, but we most of the time get the upward slope. The liquidity preference theory (LPT) was devised to explain this situation.

This theory introduces the concept of a risk or liquidity premium to our equation for predicting future rates. It posits that, while the term structure (the mathematical; formula defining the yield curve) of interest rate contracts are substitutable for the most part for different maturities (i.e. a ten-year bond is partially a substitute for two consecutive five-year bonds purchased), there is a risk factor that leads to the yield curve to be upward sloping most of the time. 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.

The risk premium is the result of lesser liquidity of long maturity interest rate contracts, as well as the higher risk of default the more we delay the date the repayment. In a two-way relationship, the lower marketability of long-term instruments leads to their lower liquidity, and that also contributes to a higher interest rate on a consistent basis.

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. There is a small qualitative difference between long and short term debt instruments, quantified in the risk premium, which leads to the sloping upward curve, and the observed phenomenon of higher rates at higher maturities most of the time.

The risk premium of the LPT assumes that all investors have similar preferences, and for practical, and easily understood reasons, choose to demand additional compensation at higher maturities for higher risk. But what if different investors do not equally value each segment of the maturity structure at the same degree? In other words, what if there are inherent, qualitative differences between maturities as perceived by investors, which leads to the conclusion that different maturities are not substitutable to each other in terms of the role that they play in investor portfolios? This supposition is the subject of the market segmentation theory discussed in the following section.

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Next, part 4 >> Market Segmentation Theory >>

Previous, part 2 << Pure Expectation Theory <<

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