Basics of Corporate Finance

Liquidity Preference Theory

3. Liquidity Preference Theory The liquidity preference theory is based on the observation that long-term securities often yield more than short-term securities. Two reasons are given to explain this:

Investors generally prefer short-term securities, which are more liquid and less expensive to buy and sell. Investors require higher yield on long-term instruments to compensate for the higher cost.

Borrowers dislike short-term debt because it exposes them to the risk of having to roll over the debt or raise new principal under adverse conditions (such as a rise in rates). Borrowers will pay a higher rate for long-term debt than for short-term debt, all other factors being held constant.

Under these "normal" conditions, there is a positive correlation between risk premium increases and maturity. Therefore, the "normal" yield curve slopes upward.

There is no evidence that any of these theories clearly explains the shape of the yield curve and its changes. However, each theory has some merit, and all three theories are discussed by participants in the markets as if they were valid.

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