If the expectation hypothesis holds, what is the marketâs expectation of one-year interest rate two years from now? B. Interest: Theory # 1. III. The liquidity preference theory, on the other hand, confines the influences on the rate of interest to the demand for and supply of money for hoarding. Liquidity refers to how easily an investment can be sold for cash. Market Segmentation Hypothesis 3. more Understanding Treasury Notes Liquidity Premium Hypothesis: Investors are risk averse and would prefer liquidity and consequently short-term investments. 10 pts] Briefly describe the expectations hypothesis, and how the liquidity preference theory accounts for the observation that the yield curve tends to be upward sloped, rather than what is predicted by the expectations hypothesis. extra compensation) Why? This theory is an extension of the Pure Expectation Theory. Expert Answer Expectation Theory :It is a interest rate theory and focuses on explaining the term structure of interest rate which is dependent on the shorter term segment This theory is â¦ According to the market expectations hypothesis, the various maturities are supposed to be the perfect substitutes. Liquidity Preference Theory. Duration measures the price risk of holding a bond. Liquidity Preference Theory Definition. 2. It adds a premium called liquidity premium Liquidity Premium A liquidity premium compensates investors for investing in securities with low liquidity. The Expectations Hypothesis 2. The biased expectations theory is a theory that the future value of interest rates is equal to the summation of market expectations. Setting: 1. As mentioned above, the local expectations theory is a variation of the pure expectations theory. Liquidity Preference Theory. A. b _____ occurs when there is an excessive demand for goods and services as a result of large increases in the money supply: a. Speculative inflation Administrative inflation b. What is the difference between the expectations theory and the liquidity preference theory? The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. The longer they prefer liquidity the preference would be for short-term investments. Statement: 1. This is because the expectations theory of term structure holds with constant term premiums in the form of: f n,t =E t (y1,t +n ) +Î n: Liquidity Preference (Premium) Theory by Hicks : This theory is one of the two forms of biased expectations theory. Individuals require a liquidity pr emium to hold less liquid, longer maturity bonds: there is an associated price discount. The percentage change in the associated price discount going to the next longest maturity is always positive. The mathematical representation of market expectations hypothesis explaining the yield curve is given by the following formula: (1 + i lt) n = (1 + i year1 st) (1 + i year2 st) (1 + i year3 st) (1 + i yearn st). The liquidity preference theory holds that interest rates are determined by the: ... d. the expectations hypothesis. BF2201 Term Structure & Interest Rate Sensitivity Nanyang Business School 17 Liquidity Preference Theory To hold longer-term bonds, investors may require a liquidity premium (i.e. Preferred Habitat Theory (Maturity Preference Theory) Theories of The Term Structure of Interest Rates Unbiased Expectations Theoryâ (Irving Fisher and Fredrick Lutz). Liquidity Preference Theory 3. In other words, the interest rate is the âpriceâ for money.