The liquidity premium theory implies that the yield curve is normally:[Fill in the blank]

Question

BlackTom AI · Accepted Answer

The liquidity premium theory addresses the shape of the yield curve by incorporating a premium for holding longer-term bonds, reflecting increased risk and decreased liquidity over time.
Option a: Decreasing. This would imply longer maturities have lower yields, which contradicts the idea that investors require a premium to lock in funds for a longer horizon. The liquidity premium tends to push longer-term yields higher, not lower.
Option b: Humped. A humped curve has a rise at short to intermediate maturities followed by a decline at longer maturities. Liquidity premium theory does not typically predict a peak and subsequent drop; it emphasizes upward pressure on longer maturities due to the added liquidity risk premium, making a hump unlikely in the normal case.
Option c: Increasing. The core implication is that longer-term bonds must offer higher yields to compensate for greater liquidity risk and potential for principal fluctuations over time. This results in an upward-sloping (normal) yield curve in typical conditions.
Option d: Flat. A flat curve would mean yields are the same across maturities, which ignores the term premium highlighted by the liquidity premium theory. In most scenarios, the added risk of longer horizons prevents a perfectly flat shape.
In summary, the theory justifies higher longer-term yields to reward investors for tying up funds longer, making the increasing option the consistent choice with the theory.

The liquidity premium theory implies that the yield curve is normally:[Fill in the blank]

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