36.According to the liquidity premium theory of the term structure of interest rates, if the one-year bond rate is expected to be 3 %, 5 %, and 9 % over each of the next three years, and if the liquidity premium on a three-year bond is 2 %, then the interest rate on a three-year bond is: 37. The risk premium is the liquidity premium that increases with the term of the bond. These returns cover a period from 1986-2011 and were examined and attested by Baker Tilly, an independent accounting firm. Short-term bonds have less interest rate risk than long-term bonds, because their prices change less for a given changes in interest rates. Marketwatch: An Inverted Yield Curve Is a Recession Indicator, but Only in the U.S. Countdown to recession: What an inverted yield curve means - Reuters, What Is Market Segmentation Theory? Positive humpedness (aka positive butterfly) occurs when the intermediate-term yields are lower than either short- or long-term durations; negative humpedness (aka negative butterfly) is the inverse: short-term and long-term yields are lower than intermediate term yields. This is often called a flight to quality, such as occurred during the 2008 Great Recession, when interest rates on Treasury bills actually went negative — people were actually paying more for T-bills than they would receive at maturity! There are different kinds of yield curves that are differentiated by the underlying security. While it is generally accepted that there is no credit or default risk for Treasuries, most corporate bonds do have a credit rating that can change because of changing business or economic conditions. The liquidity premium theory asserts that long-term interest rates not only reflect investors' assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium. The size of the liquidity premium may also be time-varying. Simply put, the longer the time to maturity, the higher the yield. The yield of bonds of different terms tend to move together. A shift with a twist is one that involves either a flattening or an increasing curvature to the yield curve or it may involve a steepening of the curve where the yield spread becomes either wider or narrower as one progresses from shorter durations to longer durations. There are many different factors that would cause differences in the supply and demand for bonds of a certain maturity, but much of that difference will depend on current interest rates and expected future interest rates. The inverted yield curve can also predict recessions, since this curve has preceded all 9 recessions in the United States since 1955. This term premium is the increment required to induce investors to hold longer-term ("riskier") securities. There are several versions of the expectations hypothesis, but essentially, the expectations hypothesis (aka Pure Expectation Theory, Unbiased Expectations Theory) states that different term bonds can be viewed as a series of 1-period bonds, with yields of each period bond equal to the expected short-term interest rate for that period. Economists have devised other theories to account for these situations, including the expectations theory, which states that the yield curve reflects future expectations about interest rates. For instance, when interest rates rise, the demand for short-term bonds increases faster than the demand for long-term bonds, flattening the yield curve. For instance, if short-term rates are a lot lower than long-term rates, then bond issuers will issue more short-term bonds to take advantage of the lower rates even though they would prefer longer maturities to match their expected income streams; likewise, lenders tend to buy long-term debt if the yield advantage is significant, even though carrying long-term debt has increased risks. Liquidity Premium Theory The liquidity premium theory accepts the expectations approach that expectations of changes in interest rates affect the term structure of interest rates. The actual shape of the yield curve depends on the supply and demand for specific bond terms, which, in turn, depends on economic conditions, fiscal policies, expected forward rates, inflation, foreign exchange rates, foreign capital inflows and outflows, credit ratings of the bonds, tax policies, and the current state of the economy. There is no reason to believe that they will be the actual rates, especially for extended forecasts, but, nonetheless, the expected rates still influence present rates. According to the expectations hypothesis, if future interest rates are expected to rise, then the yield curve slopes upward, with longer term bonds paying higher yields. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that … A yield shift with humpedness is one where the yields for intermediate durations changes by a different amount from either short- or long-term durations. The liquidity premium theory focuses on the question of how quickly an asset can be sold in the market without lowering its stated price. Duration measures the price risk of holding a bond. NASDAQ data is at least 15 minutes delayed. The liquidity premium theory (LTP) is an aspect of both the expectancy theory (ET) and the segmented markets theory (SMT).
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