Chartered Financial Analyst (CFA) Practice Exam Level 2

What does an upward sloping yield curve signify according to Liquidity Premium Theory?

1. Short-term interest rates are lower than long-term interest rates

2. Liquidity premium decreases over time

3. Liquidity premium grows over time

4. Investors are indifferent between short and long-term securities

The correct answer is: Liquidity premium grows over time

An upward sloping yield curve, as interpreted within the framework of Liquidity Premium Theory, suggests that liquidity premiums grow over time. This theory posits that investors demand a higher yield for holding longer-term securities, which carry more risk and uncertainty compared to short-term securities. As time goes on, the uncertainty associated with the holding period—such as inflation risk, interest rate risk, and the likelihood of economic changes—tends to increase. Consequently, investors require a greater liquidity premium to compensate for the additional risks involved with long-term investments. This premium results in long-term interest rates being higher than short-term rates, manifesting as an upward sloping yield curve. While short-term interest rates being lower than long-term interest rates is a characteristic of the upward sloping yield curve, it does not directly relate to the liquidity premium's behavior over time. The notion of a decreasing liquidity premium over time contradicts the upward slope of the yield curve. Lastly, if investors were indifferent between short-term and long-term securities, yields would not exhibit the upward slope expected in this context, as there would be no incentive for higher long-term yields.