Archive / Investment Adviser (Level 1) / Investing in Fixed Income Securities

nism-series-xa-liquidity-preference-theory-yield-curve[ INVESTMENT ADVISER (LEVEL 1) ]

According to the 'Liquidity Preference Theory' of term structure of interest rates, why is the normal yield curve typically upward sloping?

[ A ]Long-term bonds have zero interest rate sensitivity compared to money market bills.

[ B ]Borrowers prefer to issue short-term debt and pay massive penalty premiums to long-term lenders.

[ C ]Central banks legally mandate that 10-year yields must equal three times 91-day T-Bill yields.

[ D ]Investors prefer short-term liquidity and demand an additional term/liquidity risk premium to lock up capital in longer-maturity bonds.[ CORRECT ]

Takeaway

Liquidity Preference Theory explains the normal upward-sloping yield curve as compensation: investors prefer short-term liquidity and demand an additional term/liquidity premium to be induced into locking capital away in longer-dated, more price-volatile bonds.

Derivation

Longer-maturity bonds carry greater price sensitivity to interest rate changes (higher duration) and tie up an investor's capital for longer, both of which investors find less attractive than holding short-term instruments they can redeploy quickly. To compensate lenders for accepting this reduced liquidity and higher price-volatility risk, borrowers must offer progressively higher yields as maturity extends — even if the market's actual expectation for future short-term rates is flat — producing the characteristic upward slope observed in a 'normal' yield curve.

Why the others fail

A — Long-term bonds have zero interest rate sensitivity compared to money market bills.

Long-term bonds are in fact more, not less, sensitive to interest rate changes than short-term money market bills — the opposite of the claim that they carry zero interest rate sensitivity.

B — Borrowers prefer to issue short-term debt and pay massive penalty premiums to long-term lenders.

Liquidity Preference Theory concerns investors' compensation demand for holding illiquid long-term debt.

C — Central banks legally mandate that 10-year yields must equal three times 91-day T-Bill yields.

There is no central bank mandate fixing 10-year yields as a rigid multiple of 91-day T-Bill yields; yield curve shape emerges from market forces and investor preferences.