1. Dec 2019 Question 3
b) With the aid of diagrams, explain the liquidity premium theory
Liquidity Premium Theory Yield Curve
Liquidity premium, int
Expectations Theory Yield Curve
0 5 10 15 20
Years of maturity, n
it + iet+1 + iet+2 +. . . + iet+(n– 1) int
lnt =
n
Interest rates on different maturity bonds move together over time, as explained by the first
term in the equation. Yield curves tend to slope upward when short-term rates are low and
to be inverted when short-term rates are high, as explained by the liquidity premium term
in the first case and by a low expected average in the second case. Yield curves typically
slope upward, as explained by a larger liquidity premium as the term to maturity lengthens.
Short-term bonds require less risk due to fewer potential fluctuations in the short term (for
example, 3 months/ 6 months) and thus provide a lower return, as shown by the yield
curve. Investors demand a premium in exchange for the convenience of liquidity over long-
term investment (like 10 years). The liquidity premium theory is consistent with this
explanation. Investors can make long-term decisions, but they must be compensated for
uncertain interest rate scenarios. As a result, incrementally higher returns are explained by
a higher liquidity premium for rewarding investors who take on material interest rate risks
that are unknown to them.
2. June 2019 Question 3
b) Briefly explain the Liquidity Premium Theory including two (2) possible shapes of yield
curves related to the theory.
The concept of liquidity premium theory is widely used in bond markets. Simply put, it
denotes the presence of risk-reward in investment. Taking additional risks allows investors
to earn higher returns. It derived from the phrase, "the greater the risk, the greater the
reward." Investors take a variety of risks, and as a result, they have a chance to earn higher
returns.
Two possible shapes of yield curves are
b) With the aid of diagrams, explain the liquidity premium theory
Liquidity Premium Theory Yield Curve
Liquidity premium, int
Expectations Theory Yield Curve
0 5 10 15 20
Years of maturity, n
it + iet+1 + iet+2 +. . . + iet+(n– 1) int
lnt =
n
Interest rates on different maturity bonds move together over time, as explained by the first
term in the equation. Yield curves tend to slope upward when short-term rates are low and
to be inverted when short-term rates are high, as explained by the liquidity premium term
in the first case and by a low expected average in the second case. Yield curves typically
slope upward, as explained by a larger liquidity premium as the term to maturity lengthens.
Short-term bonds require less risk due to fewer potential fluctuations in the short term (for
example, 3 months/ 6 months) and thus provide a lower return, as shown by the yield
curve. Investors demand a premium in exchange for the convenience of liquidity over long-
term investment (like 10 years). The liquidity premium theory is consistent with this
explanation. Investors can make long-term decisions, but they must be compensated for
uncertain interest rate scenarios. As a result, incrementally higher returns are explained by
a higher liquidity premium for rewarding investors who take on material interest rate risks
that are unknown to them.
2. June 2019 Question 3
b) Briefly explain the Liquidity Premium Theory including two (2) possible shapes of yield
curves related to the theory.
The concept of liquidity premium theory is widely used in bond markets. Simply put, it
denotes the presence of risk-reward in investment. Taking additional risks allows investors
to earn higher returns. It derived from the phrase, "the greater the risk, the greater the
reward." Investors take a variety of risks, and as a result, they have a chance to earn higher
returns.
Two possible shapes of yield curves are
