Question

If the liquidity preference hypothesis is true, what shape should the term structure curve have in a period where interest rates are expected to be constant

Answer 1

Upward sloping

Step-by-step explanation:

Liquidity preference theory states that investors will demand higher interest rate or premiums on assets that have a longer term maturity that have higher risk.

The more liquid assets are the less the interest demanded. Cash is the most sought after asset.

Short term assets carry lower interest because investors have more liquidity on them.

If yield to maturity is plotted against maturity date and interest rate is constant, there will be an upward slope.

This is because when rates are stable uncertainty is lower. Investors are confident that risk is also constant