Yield curve and Liquidity Preference Theory

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fwvagabond

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I am using Schweser Notes and their question bank.

The Notes says that Liquidity Preference Theory is the preference for liquidity on top of the expectation theory. And the Notes also says explicitly that because of this, the shape of the yield curve can be any.

However, I have encountered more than a few questions in the Question Bank that state the shape based on this theory has to be upward sloping.

Can anyone explain this? Which is right?

(I have to say this...this is so typical Schweser. The quality of its products is sometimes very questionable. For L2, I am definitely switching prep material.)
 
According to the LP theory investors in general have a preference for liquidity... investors demand a higher yield for bonds with longer maturities. Therefore all else equal, the yield curve will be upward sloping.

What I think they are driving at, in the notes, is that LP advocates do not deny the existence of the pure expectations yield curve, it's just they theorize that a LP premium exists for bonds and therefore, without factoring in expectations, the yield curve will be upward sloping. Therefore, an upward sloping curve is not an indication of rising rates (according to LP), but can be some overtly offsetting effect of either A) expectations or B) a change in the liquidity preference. I think about like this, unless there can be some sort of quantitative devide between LP and PE theories, you can't easily seperate the two effects, expectations and LP because they are two highly linked effects, if LP exists that is.



Edited 1 time(s). Last edit at Sunday, April 23, 2006 at 11:26PM by jamespucyk.
 
jamespucyk,

your reply makes sense, and I have considered that, too. But the Notes states:

Book 5, page 57: "LP theory believes that, in addition to expectations about future short term rates, investors requrie a risk premium..."

Book 5, page 58: "under the LP theory, the yield curve may take on any of the shapes we have identified. If rates are expected to fall a great deal in the future, even adding a LP to the resulting negatively sloped yield curve can result in a downward sloping yield curve. A humped yield curve could still be humped even with a LP added to all the yields..."

So explicitly stated in the second quote, it makes me wonder if they actually made a mistake in the Notes.
 
Consider a situation where there is only 3 yield, short, medium and long term yields and they are respectivly 4.5%, 5% and 5.5%. Under Expectations this mean that people expect the short term yields to rise in the future.

Now lets assume we can determine the liquidity premium on all yields. Let us assume the Liquidity premiums are 0, .5% and 1%, under this situation, the yield curve is actually flat at 4.5% and the upward slope is all to do with the liquidity premium. Stated otherwise, people WILL NOT buy bonds of longer maturities at prices at par with short term yield, they demand a discount; a higher yield. The yield curve is a function of the liquidity premium demanded in the bond market.

Now just to round off what I was trying to explain consider a situation with the same yield cure, where the liquidity premiums on short, medium and long term bonds are 0, .25% and .5%, in this situation the expectations yield curve is 4.5%, 4.75% and 5%, less steep than the 4.5 - 5.5% after factoring out the liquidity preference.

There is one other situation that comes to mind as well. A situation with the same yield curve and with Liquidity premiums of 0%, 0.75% and 1.25%, in this case the expectations yield curve is actually downward sloping; i.e. factoring out the liquidity premiums the curve is actually 4.5%, 4.25% and 4%, in this case the upward curve is altogether a function of liquidity premium.
 
fwvagabond Wrote:
-------------------------------------------------------
> Book 5, page 58: "under the LP theory, the yield
> curve may take on any of the shapes we have
> identified. If rates are expected to fall a great
> deal in the future, even adding a LP to the
> resulting negatively sloped yield curve can result
> in a downward sloping yield curve. A humped yield
> curve could still be humped even with a LP added
> to all the yields..."
>
> So explicitly stated in the second quote, it makes
> me wonder if they actually made a mistake in the
> Notes.

Just to answer this question, assume that the LP's are stable at 0.25 and 0.5% for medium and long term bonds. Under a situation where the expectations are for short term rates to drop in the future you will get a situation, where the unadjusted yield curve stands at 4.5%, 4.25% and 4%, you actually have a situation, factoring out the LPs of an expectations curve of 4.5%, 4% and 3.5%, therefore even with the LPs you have a downward sloping curve.
 
I just have real trouble describing anything besides camels as "humped". Good job here james..
 
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