Liquidity Premium Theory

6 Key excerpts on "Liquidity Premium Theory"

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  eBook - PDF

  Financial Markets & Institutions

  • Jeff Madura(Author)
  • 2020(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  As expectations about consecutive short-term rates change over time, the average of these rates would be less volatile than the individual short-term rates. Thus, long-term rates would be much more stable than short-term rates. 3-3b Liquidity Premium Theory Some investors may prefer to own short-term rather than long-term securities because a shorter maturity represents greater liquidity. Therefore, they may be willing to hold long-term securities only if compensated by a premium for the lower degree of liquid- ity. Although long-term securities can be liquidated prior to maturity, their prices are more sensitive to interest rate movements. Short-term securities are normally consid- ered to be more liquid because they are more likely to be converted to cash without a loss in value. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 56 Part 1: Overview of the Financial Environment The preference for the more liquid short-term securities places upward pressure on the slope of a yield curve. Liquidity may be a more critical factor to investors at some times than at others, and the liquidity premium will accordingly change over time. As it does, the yield curve will change in tandem. The model that explains these movements is called Liquidity Premium Theory (or liquidity preference theory). Exhibit 3.4 contains three graphs that reflect the existence of both expectations theory and a liquidity premium. Each graph shows different interest rate expectations held by the market.

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  eBook - ePub

  2022 CFA Program Curriculum Level II Box Set

  • (Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term and that these premiums increase with maturity. Thus, given an expectation of unchanging short-term spot rates, liquidity preference theory predicts an upward-sloping yield curve. The forward rate provides an estimate of the expected spot rate that is biased upward by the amount of the liquidity premium, which invalidates the unbiased expectations theory. The liquidity premium for each consecutive future period should be no smaller than that for the prior period.

  For example, the US Treasury offers bonds that mature in 30 years. Most investors, however, have shorter investment horizons than 30 years. For investors to hold these bonds, they would demand a higher return for taking the risk that the yield curve changes and that they must sell the bond prior to maturity at an uncertain price. That incrementally higher return is the liquidity premium. Note that this premium is not to be confused with a yield premium for the lack of liquidity that thinly traded bonds may bear. Rather, it is a premium applying to all long-term bonds, including those with deep markets.

  Liquidity preference theory fails to offer a complete explanation of the term structure. Rather, it simply argues for the existence of liquidity premiums. For example, a downward-sloping yield curve could still be consistent with the existence of liquidity premiums if one of the factors underlying the shape of the curve is an expectation of deflation (i.e., a negative rate of inflation resulting from monetary or fiscal policy actions). Expectations of sharply declining spot rates may also result in a downward-sloping yield curve if the expected decline in interest rates is severe enough to offset the effect of the liquidity premiums.

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  eBook - PDF

  Bonds

  A Concise Guide for Investors

  • M. Choudhry(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  This is because the borrower might not be able to repay the loan over the longer time period as he might for instance, go bankrupt in that period. For this reason longer-dated yields should be higher than short-dated yields, to recompense the lender for the higher risk exposure during the term of the loan. 7 We can consider this theory in terms of inflation expectations as well. Where inflation is expected to remain roughly stable over time, the market would anticipate a positive yield curve. However the expectations hypoth- esis cannot by itself explain this phenomenon, as under stable inflationary conditions one would expect a flat yield curve. The risk inherent in longer- dated investments, or the liquidity preference theory, seeks to explain a positive-shaped curve. Generally borrowers prefer to borrow over as long a term as possible, while lenders will wish to lend over as short a term as possible. Therefore, as we first stated, lenders have to be compensated for lending over the longer term; this compensation is considered a premium for a loss in liquidity for the lender. The premium is increased the further the investor lends across the term structure, so that the longest-dated invest- Bonds 122 ments will, all else being equal, have the highest yield. So the liquidity preference theory states that the yield curve should almost always be upward sloping, reflecting bondholders’ preference for the liquidity and lower risk of shorter-dated bonds. An inverted yield curve could still be explained by the liquidity preference theory when it is combined with the unbiased expectations hypothesis. A humped yield curve might be viewed as a combination of an inverted yield curve together with a positive-sloping liquidity preference curve. The difference between a yield curve explained by unbiased expecta- tions and an actual observed yield curve is sometimes referred to as the liquidity premium.

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  Keynes's General Theory, the Rate of Interest and Keynesian' Economics

  • G. Tily(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  In practice there is a reward for liquidity. While money is the liquid asset par excellence, as emphasised throughout this discus- sion, the liquid asset of most importance is the bill. The reward for illiquidity is therefore more fully identified as a spread between long- and short-term The Theory of Liquidity Preference and Debt-Management Policy 201 government assets. The bill rate on short-term lending to the government is in turn related to the discount rate as the short rate underpinning lending to the private sector. The latter can simply be set so that it is compatible with the desired structure of interest rates in the economy. The long-term rate of interest depends on the short rate, the liquidity premium and also any risk premia. The latter reflects the premium for lending to companies rather than the government, but also including a premium to reflect the likelihood of default. The risk of default applies to both governments and companies and may, of course, be cyclical. An alternative statement of the conclusion of Keynes's theory of liquidity preference is that the liquidity premium can be brought under control. With the discount rate under control, the monetary authorities are able to set the spectrum of interest rates. A spectrum from liz per cent short to 2 1 1z per cent long is feasible and not a priori absurd. 7.5 Debt-management and monetary policies At the NDE, Keynes set out the practical policies that would allow the government to set rates of interest across the whole spectrum of liquidity (as discussed in Chapter 3). These rates would in turn underpin the prices for all other debt. The theory of liquidity preference determines the rate of interest by the interaction of firms', the government's and households' preferences towards holding and borrowing wealth with different degrees of liquidity.

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  eBook - ePub

  Market Consistency

  Model Calibration in Imperfect Markets

  • Malcolm Kemp(Author)
  • 2009(Publication Date)
  • Wiley

    (Publisher)

  d. If markets were perfect, then organisations known to be economically solvent would be able to access whatever liquidity they needed when they needed it. So, liquidity premiums are to some extent costs incurred by organisations because markets are (or are believed to be) imperfect and/or because there is uncertainty in the financial health of the entity seeking funding. Liquidity premiums can be expected to exhibit strong option-like characteristics, since they involve an option-like protection against the risk that markets might become materially less perfect at an inopportune time. They are therefore likely to vary significantly depending on the liquidity ‘climate’.

  The challenge is that whilst most commentators seem to agree that some types of highly liquid assets seem to command a ‘liquidity’ price premium and some less liquid assets ought to command a corresponding ‘illiquidity’ spread premium, there is much less consensus on:

  (a) What precisely we mean by the term ‘liquidity’ and what the (illiquidity) premium actually consists of, i.e. what exactly it is recompensing the investor for; (b) What impact, if any, such issues should have on market consistent valuations; and (c) Even if it is thought that (il)liquidity premia should influence market consistent valuations how to work out the size of the relevant premia in the first place.

  In the rest of this chapter we explore these challenges further.

  6.5 EXACTLY WHAT IS LIQUIDITY?

  6.5.1 Different points of view

  Brunetti and Caldarera (2006) define liquidity as ‘the ability to trade quickly any amount at the market price with no additional cost’.

  This definition, simple though it seems, actually hides a divergence of viewpoints on what exactly liquidity is in the first place. Essentially, we can characterise liquidity in several different ways all staying within the spirit of the above definition:

  Principle P29: Liquidity is a concept that is quite complicated to pin down (and therefore to measure). Emphasising some elements of the concept over others can materially influence how much (il)liquidity premium we might expect different instruments to exhibit.

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  The Post-Bubble US Economy

  Implications for Financial Markets and the Economy

  • P. Arestis, E. Karakitsos(Authors)
  • 2004(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The Long-term Risks to US Financial Markets 273 Since the arbitrage equation holds for expected rather than actual yields it is better described as an equilibrium relationship, for any given holding period. The left-hand side of (1) represents the total holding period return (i.e. current yield plus expected capital gains), of the long maturity, say ten- year. The first term on the right hand side of (1) is the yield on the short maturity, say three-month, and the last two terms, in parenthesis, represent the risk premium between the yields of the two maturities. The risk premium consists of two components, the inflation premium and the preferred habi- tat premium (see below). Although the arbitrage relationship holds between any two maturities, it is convenient to think of the short-term interest rate, r, as the instrument of monetary policy, which acts as an anchor to the yields of all maturities. Equation (1) can be written in a number of different ways, such as: (R r e ) g e p e a (1a) In this form it asserts that the spread between the long and the short yield reflects investors’ expected capital gains (or losses) from holding the ten-year bond (g e ) plus a risk premium for convincing investors to deviate from their preferred habitat ( ), plus an inflation premium based on expected inflation over the holding period ( p e ). The preferred habitat premium arises from the fact that in minimising risk investors will try to match the maturities of their assets and liabilities (preferred habitat). Hence, if they are to take some risk and deviate from their preferred habitat they should be compensated by receiving a corresponding premium. For example, if investors have funds available for investment for only six months then without any risk they can invest in a six-month bond. However, if they were to invest in a longer bond they would do so only if they were sufficiently compensated for the risk they will assume.

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