b. Explain this yield curve using the unbiased expectations theory and the liqui

Question

b. Explain this yield curve using the unbiased expectations theory and the liquidity preference theory. proposes that the rise in the yield curve over the next five years is based on expectations by investors that prevailing interest rates in the market will rise. Liquidity preference theory Unbiased expectation theory buys into the idea that investors have a preference toward more liquid investments, and that borrowers offer higher rates for longer-term investments as a stimulus for longer, more illiquid investment.

Explanation / Answer

Unbiased expectation theroy: forward rates are unbiased predictor of future spot rate. Long term rates can be determined by the short term interest rates. Proposes that the rise in the yield curve over the next five years is based on expectations by investors that prevailing interest rates in the market will rise.Expectations determine the shape of yield curve.

Liquidity Preference theory: investors prefer liquidity and short term securities other things being equal. Investors have a preference toward more liquid investments, and that borrowers offer higher rates for longer-term investments as a stimulus for longer, more illiquid investment.

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