Under the liquidity premium theory,the shape of the yield curve depends on
A) the relative return of investments in common stocks versus investments in corporate bonds.
B) the size of the federal government's budget deficit.
C) government tax treatment of long-term versus short-term bonds.
D) the expected pattern of future short-term rates and the size of the term premium at each maturity.

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, the shape of the yield curve depends on the expected pattern of future short-term rates and the size of the term premium at each maturity. The theory suggests that investors will require a higher yield (term premium) for longer-term bonds to compensate for the greater uncertainty and risk associated with these investments. The expected pattern of future short-term rates also plays a role in determining the shape of the yield curve, as changes in short-term rates can impact the attractiveness of different maturities of bonds. Therefore, the correct answer is D.

Under the Liquidity Premium Theory,the Shape of the Yield Curve