Explain about the liquidity premium theory of the term structure of interest rates.
Liquidity premium theory:
Liquidity premium theory asserts which, into a world of uncertainty, lenders and investors will want to hold assets that can be converted in cash rapidly. Thus they will demand a liquidity premium for holding long term debt. On the other hand, similarly dislike for uncertainty causes borrowers (for illustration, firms and governments) to favour to borrow for a longer period at a rate that is certain recently – thus they will be willing to pay a liquidity premium and, hence, a higher rate of interest onto their longer-term debt. It means that the yield curve will usually be upward sloping, while the absence of any other affects. In reality, we require to consider the combined effect of expectations together along with liquidity inclination. A downward sloping yield curve will happen when expectations of an interest rate fall are adequate to offset the liquidity premium.