1)Under liquidity premium theory, R(2)=GM of r(1) & E(r¹,1)+LP.
2)In general, R(2)= r(1)+ f(1,1)
So can we say that f(1,1) includes LP?
In the both cases above 1 and 2 if we equate, isnt so that LHS should be equal to RHS?
Or the difference between the 2 R(2) is LP.
Am i thinking correctly?
DeyAbhishekPro
Fixed Income
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Abhishek you are going way too far with this theory and it is not covered in the curriculum to what you are asking for your reference the write up in the core for liquidity preference theory is very short and it’s approximately of only one page so I am attaching it here you could just go through it and clear yourself with what we are supposed to know about it.
“Whereas expectations theories leave no room for risk aversion, liquidity preference theory attempts to account for it. Liquidity preference theory asserts that 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.
“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.
In summary, liquidity preference theory claims that lenders require a liquidity premium as an incentive to lend long term. Thus, forward rates derived from the current yield curve provide an upwardly biased estimate of expected future spot rates. Although downward-sloping or hump-shaped yield curves may sometimes occur, the existence of liquidity premiums implies that the yield curve will typically be upward sloping.”
Excerpt From
2022 CFA Program Level II Volume 4 Equity and Fixed Income
CFA Institute
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