THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 160

128

PA R T I I

Financial Markets
Liquidity Premium and Preferred
Habitat Theories Yield Curve

Interest
Rate, int

Liquidity Premium, lnt

Expectations Theory
Yield Curve

0

5

10

15

20

25

30

Years to Maturity, n

FIGURE 6-5

The Relationship Between the Liquidity Premium and Preferred Habitat
Theories and Expectations Theory

Because the liquidity premium is always positive and grows as the term to maturity increases,
the yield curve implied by the liquidity premium and preferred habitat theories is always above
the yield curve implied by the expectations theory and has a steeper slope. Note that the yield
curve implied by the expectations theory is drawn under the scenario of unchanging future
one-year interest rates.

APP LI CAT IO N

Liquidity Premium Theory
Let s suppose that the one-year interest rate over the next five years is expected to
be 5%, 6%, 7%, 8%, and 9%. Investors preferences for holding short-term bonds
have the liquidity premiums for one-year to five-year bonds as 0%, 0.25%, 0.5%,
0.75%, and 1.0%, respectively. What is the interest rate on a two-year bond and a
five-year bond? Compare these findings with the answer in the previous Application
dealing with the pure expectations theory.

Solution

The interest rate on the two-year bond would be 5.75%.
int +

i t + i et + 1 + i et + 2 , . . . , i et + (n * 1)
n

, lnt

where
it + year 1 interest rate + 5%
i et + 1

+ year 2 interest rate + 6%

l 2t + liquidity premium + 0.25%
n + number of years + 2
Thus
i2t +

5% , 6%
, 0.25% + 5.75%
2