Investments, tenth edition

  Liquidity Preference 

 We noted earlier that short-term investors will be unwilling to hold long-term bonds unless 

the forward rate exceeds the expected short interest rate,  f  

2

   .   E ( r  

2

 ), whereas long-term 

investors will be unwilling to hold short bonds unless 

 E ( r  

2

 )  .   f  

2

 

. In other words, both groups of investors 

require a premium to hold bonds with maturities dif-

ferent from their investment horizons. Advocates of the 

    liquidity  preference  theory    of the term structure believe 

that short-term investors dominate the market so that the 

forward rate will generally exceed the expected short 

rate. The excess of  f  

2

  over  E ( r  

2

 ), the  liquidity premium,   is 

predicted to be positive. 

 

 To illustrate the differing implications of these theories 

for the term structure of interest rates, suppose the short interest rate is expected to be 

constant indefinitely. Suppose that  r  

1

   5  5% and that  E ( r  

2

 )  5  5%,  E ( r  

3

 )  5  5%, and so on. 

Under the expectations hypothesis the 2-year yield to maturity could be derived from the 

following:

    (1

1 y

2

)

2

5 (1 1 r

1

)

31 1 E(r

2

)

4

 

5 (1.05)(1.05)

  

 so that  y  

2

  equals 5%. Similarly, yields on bonds of all maturities would equal 5%. 

 The liquidity premium hypothesis also holds 

that  issuers  of bonds prefer to issue long-term 

bonds to lock in borrowing costs. How would 

this preference contribute to a positive liquidity 

premium? 

 CONCEPT CHECK