What is the liquidity premium theory of the term structure o

What is the liquidity premium theory of the term structure of interest rates? What can it explain? What are its drawbacks?

Solution

The term structure of interest rates have 3 main characteristics where the liquidity premium theory is known to explain the third characteristic of third characteristic : the bonds that have high maturity periods will give higher yields on the whole. The drawbacks of liquidity premium theory is that it doesn\'t view bonds with maturities as perfect substitutes and also it assumes that investors have no preference though the investor usually prefer short bonds on the whole.