interest rate question question

spartan1

Under the liquidity theory, if the yield curve is flat, the short term interest rate:

a. increase
b. decrease
c. remain unchanged

thisisbrianly

billbelemy22, the yield curve was a given - we were being asked to interpret the implied expectations about the direction of short term interest rates. Accordingly to LPT the yield curve represents expectations + a premium. Once you subtract the premium the implication is that short term rates are headed downwards. In other words, the premium makes flat what would otherwise (under Pure Expectations) be a downwards sloping yield curve.

rkapoor

billbelemy22 Wrote:
-------------------------------------------------------
> I went with A. Liquidity preference means even
> though it's flat, a premium is still required so
> it will increase


You just explained why it will decrease...

Londonrocks

I went with A. Liquidity preference means even though it's flat, a premium is still required so it will increase

Bluetick1010

The LPT and MST are very close though. MST can explain kinked curves much better than LPT though.

Answer is surely decrease though.

amqata

Paraguay, I think some of what you said about investors' preference for their given spot is more relevant to the Market Segmentation Theory.

The Liquidity Preference Theory simply posits a maturity premium above the expected rate. So an upwards sloping yield curve which under Pure Expectations indicates higher rates expected could in theory under LPT encompass lower or flat future rates expected.

A flat curve, as in the question, under LPT (once you account for the maturity premium) indicates lower rates expected. The maturity premium is related to inflation expectations, so theoretically the premium could be nil, in which case flat future rates might be indicated. However, this is exceptional, and the answer was surely lower rates expected.

kd26gioi

Damn, add another one to the list I got wrong. It is decrease according to the book.

btcapital

Upward sloping could be liquidity preference like now. If there was a huge demand for short term instruments for safety reasons but rates were expected to come down in the future you could still have an upward sloping curve.

As many investors have a preference to their given spot because of the rate that is given, the LPT states that the curve should be upward sloping as people need to be compensated for the excess time.

The current answer is decrease as with a flat curve implies that rates are coming down but demand is not enough to outpace the supply in the short term.

ogoluwa

According to Mr. Schweser,

""An upward sloping yield curve can be consistent with the liquidity preference theory even with expectations of declining short term interest rates.""

Which apparently negates what all you people are mentioning or am i missing something ?

joemoran

Yea this is confusing I likely got it wrong, I put that they would increase because I knew it was naturally an upward sloping line meaning long term rates are higher so to make it "flat" you would have to raise the short term end of the yield curve. I have no idea.