The key assumption of the liquidity premium theory is that investors
A) view bonds of different maturities as perfect substitutes.
B) view bonds of different maturities as completely unsubstitutable.
C) always choose the bond with the highest expected return, regardless of maturity.
D) care about both expected returns and time to maturity.

Question

Quizplus · Accepted Answer

The liquidity premium theory assumes that investors care about both expected returns and time to maturity. This means that bonds of different maturities are not perfect substitutes, as there is a premium (extra return) demanded for holding longer-term bonds due to the uncertainty and risk of tying up funds for a longer period of time.

The Key Assumption of the Liquidity Premium Theory Is That