According to the liquidity preference theory, how does the maturity risk premium (MRP) affect the yield curve?

Question

BlackTom AI · Accepted Answer

When examining the liquidity preference theory, the core idea is that longer-term securities carry greater risk and lower liquidity, so investors demand a higher return for holding them. This extra return is the maturity risk premium (MRP).
Option 1: 'MRP is zero, flattening the curve.' This is inconsistent with liquidity preference theory, which argues that investors require compensation for tying up funds for longer periods, so the premium should not be zero and the curve should not be flat due to MRP.
Option 2: 'MRP increases with maturity, steepening the upward slope.' This aligns with the theory: as maturities lengthen, investors demand more compensation for risk and lower liquidity, causing MRP to rise and the yield curve to slope upward more steeply.
Option 3: 'MRP decreases with maturity, inverting the curve.' This contradicts the fundamental premise of the theory; a decreasing MRP would reduce the incentive for longer-term bonds, not produce a typical positive slope, and would more likely cause inversion, which the theory does not predict.
Option 4: 'MRP is constant, having no effect.' A constant MRP implies no additional yield for longer maturities, which would yield a flat curve, again contrary to liquidity preference theory that attributes a rising MRP to longer horizons.
Overall, the correct framing is that longer maturities incur a higher MRP, leading to a steeper upward-sloping yield curve, while the other options misstate the behavior or impact of MRP on the curve.

Business Finance Exam 2 Practice

According to the liquidity preference theory, how does the maturity risk premium (MRP) affect the yield curve?

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