Overview of Liquidity Preference Theory
The Liquidity Preference Theory is one of the several theories that try to explain the relation between the yield of a debt instrument and its maturity period. The Liquidity Preference Theory is also known as the “liquidity preference hypothesis”.
Origin of Liquidity Preference Theory
The Liquidity Preference Theory originated from the Pure Expectations Theory. It has also been described as its offshoot.
Explanation Provided by Liquidity Preference Theory
As per the Liquidity Preference Theory the rates of interest over a long term also admit a premium that the investors are entitled to receive, if they possess debt instruments that have longer term periods.
They are not only concerned with what the investors may assume. According to the Liquidity Preference Theory this premium is known as the liquidity premium and the term premium.
The term premium or the liquidity premium is supposed to even out the financial risks the investors may have suffered from as a result of investment in debt instruments that had longer term periods. The great price uncertainty is one of the many risks the investors may face if they put their money in long-term debt instruments. As a result of the term premium the yield of the debt instrument that has a longer term period is higher compared to debt instruments having shorter term periods.
Concern of Liquidity Preference Theory
The main area of concern for the Liquidity Preference Theory is not liquidity. It deals more with the risks that are associated with maturity. According to the Liquidity Preference Theory the risks related to maturity are directly proportional to the length of the maturity period. This means that the debt instruments that have longer maturity periods have more risks.
Proponents of Liquidity Preference Theory
As per the exponents of the Liquidity Preference Theory the investors do not want to take risks in their investments. They normally want to be provided with a premium for putting their money in debt instruments with longer maturity periods.