CFA Level II ExamFixed IncomeMedium
A portfolio manager is analyzing a fixed-income portfolio and observes that the yield curve is upward-sloping, with short-term rates significantly lower than long-term rates. The manager believes this shape reflects investors' expectations of future inflation and a preference for liquidity in the short term. Which of the following theories best explains this observed yield curve shape?
- APure Expectations Theory
- BMarket Segmentation Theory
- CLiquidity Preference Theory
- DPreferred Habitat Theory
Show answer & explanationAnswer & explanation
Correct answer: C. Liquidity Preference Theory
The Liquidity Preference Theory posits that investors prefer short-term bonds due to their greater liquidity. To induce them to hold longer-term bonds, a liquidity premium must be offered, leading to an upward-sloping yield curve, even if future short-term rates are expected to be constant or slightly rising.
Why the other options are wrong
- A. Pure Expectations Theory suggests that the yield curve shape is determined solely by expectations of future short-term rates, without a liquidity premium.
- B. Market Segmentation Theory suggests that different investors operate in distinct maturity segments, and rates in each segment are determined independently, without necessarily linking to a general liquidity preference.
- D. Preferred Habitat Theory is a variation of Market Segmentation, suggesting investors have preferred maturities but will move to other maturities if sufficiently compensated, which doesn't fully capture the universal liquidity premium mentioned.
Liquidity Preference Theory
The Liquidity Preference Theory states that investors prefer short-term bonds because they are more liquid. To persuade them to hold longer-term bonds, a liquidity premium must be added to the expected future short-term rates, resulting in an upward-sloping yield curve.
- Investors demand a premium for holding less liquid, longer-term bonds.
- This premium increases with maturity.
- It implies that forward rates are upward-biased estimates of future spot rates.
Memory trick: Liquidity's flow makes long yields grow.