Chartered Financial Analyst (CFA) Practice Exam Level 2

What does Liquidity Premium Theory suggest about lenders' willingness to lend?

1. Lenders are more willing to lend in the long term than short term

2. Lenders are equally willing to lend in both short and long term

3. Lenders are more willing to lend in short term than long term

4. Lenders prefer to keep funds in liquid assets

The correct answer is: Lenders are more willing to lend in short term than long term

The Liquidity Premium Theory posits that investors demand a premium on long-term securities compared to short-term securities due to the higher risk and lower liquidity associated with longer maturities. Since long-term investments lock up capital for an extended period, they carry greater uncertainty regarding future interest rates and the issuer's creditworthiness, leading to a preference for liquidity. As a result, lenders tend to favor short-term lending because it allows them to maintain access to their funds more quickly and reduce exposure to the risks associated with changes in interest rates or borrower default in the long term. Essentially, the preference for short-term lending reflects a desire to keep funds readily available, which aligns with the concept of liquidity. Consequently, the theory supports the notion that lenders are more inclined to lend in the short term than in the long term, as they seek to avoid the liquidity risks associated with longer-term commitments. This is a fundamental component of the Liquidity Premium Theory, illustrating lenders’ behavior and preferences in the lending landscape.