Liquidity Preference Theory Yield Curve

Bollinger Bands Contracting
8 septembre 2020

Liquidity Preference Theory Yield Curve


The preference theory suggests that lenders prefer to lend short term while borrowers prefer to borrow long term. This makes the forward rates higher than expected future spot rates. When the yield curve is inverted, long-terms rates are lower than short-term rates, which is the opposite of the usual case, which is why the curve is said to be inverted. The other reason why there is greater demand for long-term bonds is because they have a greater potential for capital gains when interest rates decline, due to their longer duration. Under the expectations hypothesis, if the yield curve is upward-sloping, the market must expect an increase in short-term interest rates. Under this view, a rising term structure must indicate that increasing rates of inflation are expected, and the market expects short-term rates to rise throughout the relevant future.


  • Longer-term bonds are subject to greater risk, and so investors should demand a premium for holding them.
  • It maintains the former’s postulate that different maturities are substitutable, but adds that they are only partially so.
  • L is a liquidity preference function if and if , where r is the short-term interest rate and Y is the level of output in the economy.
  • Note, however, that expected future interest rates are just that — expected.

For Mäki, even though we have rational grounds for believing we know a thing or two about reality, we can be realists with no beliefs in truth or even with no knowledge at all. If we look at the figure above, there is a liquidity trap, and the range between R-Min and R-Max is known as a liquidity trap, so the interest rate only fluctuates under this trap. The yield of bonds of different terms tend to move together. Bonds of different maturities often have different yields to maturity.

Business Case Studies

The liquidity preference theory of interest was introduced by the father of modern macroeconomics, John Maynard Keynes, in his book The General Theory of Employment, Interest, and Money . A liquidity trap can occur when consumers and investors hoard cash and refuse to spend even when economic policymakers cut interest rates to stimulate economic growth. The Theory of Liquidity Preference is a special case of the Preferred Habitat Theory in which the preferred habitat is the short end of the term structure. The Preferred Habitat Theory states that the market for bonds is ‘segmented’ on the basis of the bonds’ term structure, and these “segmented” markets are linked on the basis of the preferences of bond market investors. Formally, the liquidity money curve is the locus of points in Output – Interest Rate space such that the money market is in equilibrium.

liquidity risk

This means that long-term interest rates are an unbiased predictor of future expected short-term rates. If long-term interest rates are determined solely by current expectations of future rates, then an upward sloping yield curve would imply that investors expect short-term rates to rise in the future. Because under normal conditions, the yield curve does indeed slope upward, this further implies that investors consistently seem to expect short-term rates at any given point in time. Each of the different theories of the term structure has certain implications for the shape of the yield curve as well as the interpretation of forward rates. The five theories are the unbiased expectations theory, the local expectations theory, the liquidity preference theory, the segmented markets theory, and the preferred habitat theory.

The classical or neoclassical theories do not always clash with Keynes’ liquidity-preference hypothesis. It has been noted that interest rates are not solely a monetary phenomenon. Real forces such as capital productivity and people’s thriftiness or saving significantly affect the rate of interest.

The explains people’s motives to prefer holding cash rather than investing in interest-bearing securities. The three motives explained by the model are transaction, precautionary and speculative motives. A three-year Treasury note might pay a 2% interest rate, a 10-year treasury note might pay a 4% interest rate and a 30-year treasury bond might pay a 6% interest rate.

Liquidity Preference Theory refers to money demand as measured through liquidity. Those quoted spreads can be used to determine a bond’s price. The estimated coefficient of Gap for the full sample is 500.9 and statistically significant at the 1% level. This outcome means that an order will remain in the market for 5seconds on average if a quote is 0.01 yen away from the best quote on the same side. For the subsample with lifetimes longer than 2seconds, the coefficient is more than threefold higher and statistically significant. Investigation of the dataset for robustness with algorithmic trading.

Yield Curve Slope¶

As per this theory, the yield curve will be upward sloping when the interest rates are expected to rise. The aggregate demand for money or the function of liquidity preference would be the sum of all three motives transaction, precautionary and speculative). Notice also that this real yield curve does not have the smoothness of schematic diagrams. This is because other factors affect bond prices, and therefore their yields, and these factors affect the demand for bonds with different terms differently.

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Arguably, this is more of a communication issue than one of actual policy, and less emphasis on the readiness to clean up after a sharp fall in asset prices might have been a preferable alternative. Simply put, asking for cash with a precautionary motive protects against uncertain future conditions. Assessing strategies for controlling interest rate risk, since most strategies depend on the shape of the yield curve and how it changes. The relationship between yield and maturity is summarized graphically in the yield curve.

The segmented market theory

Additionally, investors will seek different maturities to their preferred ones, i.e., their usual habitat, if the expected extra returns are large enough for them. The only variation under PHT is that investors will seek different maturities to their preferred ones, i.e., their usual habitat, if the expected extra returns are large enough for them. This theory suggests that long-term investors are not compensated for the reinvestment rate risk or interest rate risk.

The interest rate begins to fall back to point-R in such situations. Similarly, at point E2, the demand for money is higher than the supply of money, and therefore individuals will begin to sell securities. As a result, the interest rate will rise to equilibrium level R. John Maynard Keynes developed the Liquidity Preference Theory in 1936.

precautionary motive

In reality, liquidity preference involves selecting from a wide range of assets. It is certain « that the demand and supply of every type of asset have just as much right to be considered as the demand and supply of money. The liquidity preference theory cannot simultaneously account for several interest rates in the market. Keynes dismisses saving and waiting as a source of investible capital. The speculative motive is to keep one’s assets liquid to profit from future changes in interest rates or bond prices. The price of a bond and the rate of interest are inversely connected.

WealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation. This shows the relationship between the interest rate and the quantity of money the public wishes to hold. Yield maintenance is a prepayment premium that allows investors to attain the same yield as if the borrower made all scheduled interest payments. In real-world terms, the more quickly an asset can be converted into currency, the more liquid it becomes. John Maynard Keynes mentioned the concept in his book The General Theory of Employment, Interest, and Money , discussing the connection between interest rates and supply-demand.

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The general pattern is that shorter maturities have lower interest rates than longer maturities. The yield of a bond depends on the price of the bond, which in turn, depends on the supply and demand for a particular bond issue. Over time, supply and demand for particular maturity groups changes unevenly, so the yield curve shifts in different ways to reflect these differences. In the liquidity preference theory, it is said that short-term interest rates are lower than medium- and long-term interest rates. This is because investors are not compromising liquidity with longer time frames.

Thus, the entire term structure at a given time reflects the market’s current expectations of the family of future short-term rates. Based expectations theory asserts that factors other than current expectations of future short-term interest rates influence current long-term interest rates. Similarly, suppose the short-term rates are significantly lower than the long-term rates. In that case, lenders will issue more short-term bonds to take advantage of the lower rates against their preference for longer maturities to match their expected income streams. The local expectations theory is a narrower interpretation of the unbiased expectations theory, which asserts that the expected return on bonds with varying maturities is the same only over short-term periods. When higher interest rates are offered, investors give up liquidity in exchange for higher rates.

But what if different do not equally value each segment of the maturity structure at the same degree? This supposition is the subject of the market segmentation theory discussed in the following section. According to the pure expectations hypothesis, which of the following statements is correct concerning the expectations of market participants in an upward-sloping yield curve environment? Interest rates will increase and the yield curve will flatten.

BondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. Economic stimulus refers to attempts by governments or government agencies to financially kickstart growth during a difficult economic period. Short selling occurs when an investor borrows a security, sells it on the open market, and expects to buy it back later for less money. For full access to this pdf, sign in to an existing account, or purchase an annual subscription. For librarians and administrators, your personal account also provides access to institutional account management.

According to John Maynard Keynes, the demand and supply of money determine interest rates. Individuals prefer to hold liquid cash in their hands rather than invest it by preferring liquid cash. Thus, according to Keynes, interest rates are a reward for not having liquidity in their hands, and the consideration goes hand in hand with the ideology that cash is the most liquid asset. According to this theory, expected short rates can be constant if the yield curve is upward sloping. The theory states that investors should expect a higher interest rate or premium on assets with long-term maturities that pose a greater risk because, in all other circumstances, investors prefer cash or other highly liquid holdings. The risk premium of the LPT assumes that all investors have similar preferences, and for practical, and easily understood reasons, choose to demand additional compensation at higher maturities for higher risk.

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