Liquidity Premium Theory

The pure expectations theory predicts that long-term interest rates are the geometric average of expected future short-term rates.
However, this doesn't explain why upward-sloping yield curves are considered normal.
It's unlikely that investors consistently expect interest rates to rise, as rates rise and fall over the long term.
Something else must be causing long-term interest rates to be higher than pure expectations would suggest.

The liquidity premium theory suggests that the increased risk associated with longer-term securities contributes to the upward slope of the yield curve.
Long-term investments have risks, most notably interest rate risk.
- Interest rate risk: changes in interest rates have a greater impact on the value of long-term securities compared to short-term ones.
- Other risks: higher probability of default and greater sensitivity to inflation changes.
Investors generally prefer short-term investments due to these risks, seeking both value and liquidity.
Borrowers who need long-term loans offer higher interest rates to attract investors to these riskier, less liquid investments.

The extra return offered to long-term investors is called a liquidity premium.
- Premium: An additional return.
This "extra" return incentivizes investors to sacrifice liquidity and invest for the long term.
The yield curve is based on expectations and contains an upward bias.
- The observed yield curve is tilted upward compared to pure expectations.
- The premium increases for longer-term securities.
If the pure expectations yield curve is flat, the liquidity premium will cause it to slope upwards.
A liquidity premium does not preclude downward-sloping yield curve; but the observed yield curve is flatter than pure exptectations would suggest.

Assumptions:
- Investors prefer liquid assets and require a premium for holding less liquid, longer-term assets.
Prediction:
- The observed yield curve will have an upward bias exceeding what would be predicted by pure expectations alone.