Which theory of term structure states that long-term rates are equal to the geometric average of current and expected short-term rates plus a risk premium that increases with the maturity of the security?
A)The unbiased expectations theory.
B)The liquidity premium theory.
C)The loanable funds theory.
D)The market segmentation theory.

Question

Quizplus · Accepted Answer

The theory described in the question is the liquidity premium theory, which states that long-term rates are equal to the geometric average of current and expected short-term rates (as predicted by the unbiased expectations theory) plus a premium for the added risk of holding a long-term security. This premium is known as the liquidity premium and increases with the maturity of the security. Therefore, the best choice is B.

Which Theory of Term Structure States That Long-Term Rates Are