According to the liquidity premium theory of interest rates,
A)long-term spot rates are higher than the average of current and expected future short-term rates.
B)investors prefer certain maturities and will not normally switch out of those maturities.
C)investors are indifferent between different maturities if the long-term spot rates are equal to the average of current and expected future short-term rates.
D)the term structure must always be upward sloping.
E)long-term spot rates are totally unrelated to expectations of future short-term rates.

Question

Quizplus · Accepted Answer

The liquidity premium theory suggests that long-term spot rates are higher than the average of current and expected future short-term rates to compensate investors for the higher level of risk associated with investing in longer-term bonds. This is because investors face more uncertainty and price risk when investing in longer-term bonds, so they require a higher return to be compensated for this risk.

According to the Liquidity Premium Theory of Interest Rates