FINANCIAL
MARKETS AND INTEREST RATES 2-13
An upward sloping curve results from a large supply of funds
in the short-term market relative to demand and a shortage of
long-term funds. A downward sloping curve indicates strong
demand in the short-term market relative to the long-term
market. A fairly horizontal yield curve indicates that supply
and demand for funds is roughly balanced both in the short-
term and long-term markets.
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.