Preferred Habitat Theory (Maturity Preference Theory) Theories of The Term Structure of Interest Rates extra compensation) Why? In other words, the interest rate is the ‘price’ for money. Statement: 1. Liquidity Preference Theory. BF2201 Term Structure & Interest Rate Sensitivity Nanyang Business School 17 Liquidity Preference Theory To hold longer-term bonds, investors may require a liquidity premium (i.e. If the expectation hypothesis holds, what is the market’s expectation of one-year interest rate two years from now? Liquidity Preference Theory. The mathematical representation of market expectations hypothesis explaining the yield curve is given by the following formula: (1 + i lt) n = (1 + i year1 st) (1 + i year2 st) (1 + i year3 st) (1 + i yearn st). The longer they prefer liquidity the preference would be for short-term investments. 2. III. The liquidity preference theory, on the other hand, confines the influences on the rate of interest to the demand for and supply of money for hoarding. A. Expert Answer Expectation Theory :It is a interest rate theory and focuses on explaining the term structure of interest rate which is dependent on the shorter term segment This theory is … The percentage change in the associated price discount going to the next longest maturity is always positive. Setting: 1. Liquidity Premium Hypothesis: Investors are risk averse and would prefer liquidity and consequently short-term investments. Liquidity Preference Theory 3. b _____ occurs when there is an excessive demand for goods and services as a result of large increases in the money supply: a. Duration measures the price risk of holding a bond. As mentioned above, the local expectations theory is a variation of the pure expectations theory. This is because the expectations theory of term structure holds with constant term premiums in the form of: f n,t =E t (y1,t +n ) +Λ n: Liquidity Preference (Premium) Theory by Hicks : This theory is one of the two forms of biased expectations theory. more Understanding Treasury Notes The Expectations Hypothesis 2. What is the difference between the expectations theory and the liquidity preference theory? Unbiased Expectations Theory— (Irving Fisher and Fredrick Lutz). The biased expectations theory is a theory that the future value of interest rates is equal to the summation of market expectations. It adds a premium called liquidity premium Liquidity Premium A liquidity premium compensates investors for investing in securities with low liquidity. 10 pts] Briefly describe the expectations hypothesis, and how the liquidity preference theory accounts for the observation that the yield curve tends to be upward sloped, rather than what is predicted by the expectations hypothesis. 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