Essay Sample on Yield Curve and Liquidity Premium Theory

Introduction

According to (Bauer), "Yield Curve" is a line on a curve which plots the interests, at a set period of securities with the parallel ability of the company to pay its debts but and encourages investors to trade on their securities at a specified period. Horizontal "yield curve" indicates minimal presence dissimilarity between the bonds with shorter maturity dates and lasting charges for obligations with similar credit quality. This means the investor will obtain little dividends from his or her long term investment. In terms of risks, the investor is not guaranteed excess reimbursement on the investment he or she makes on long term investment (Bauer). The reasons why a yield curve flattens is because of the decrease in interest rates more than the short term interest rates. Another reason can be if the players in the economy are expecting inflation of prices to make the decision of decreasing the Federal Reserve funds and raise them when the level of inflation reduces. For example, if the Federal Reserve increases funds on its short term targets over a specified period, their long term targets will remain stable.

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Liquidity Premium and Preferred Habitat Theories

According to (Berentsen, 180), it suggests that the rate of interest charged on security with long term maturity dates will be equivalent with those securities with short maturity dates interest rates on their likelihood of happening on a specified period. The main assumptions of liquidity concept are securities with different maturity dates are alternatives which means the projected profit on one security influences the probable yield on the other bond with an unlike maturity period (Berentsen, 180). However, they prefer bods with shorter maturity period because these kinds of bonds have less interest rate risk. The yield curve usually slopes upward when there is the presence of short term interest rates (Berentsen, 180). The concept aids to forecasting the flow of short term interest rates in the future. Preferred habit theory underscores that the customers want bonds with maturity rate of less than a year since they have lesser interest risks as opposed to those bonds with maturity rate of fewer than ten years.

According to (Beer, 20), a "hampered yield" curve is a curve that depicts results when interest rates on securities with medium maturity length have fixed pay securities higher than both short term and long term bonds. They normally yield "bell-shaped curves." Which provides the investors with the future expectations on the securities they intend on investing in. It does not reimburse the investors who opt to invest in long-term bonds thereby making the investors opt to invest in short term bonds.

According to (Bauer), "Bear Flattener" is an economy where short term interest rates are increasing at an alarming rate than the long term interest rate. Taking advantage of the yield curve is a marketing strategy applied by investors whereby they buy long term securities and sell it before its maturity date so that he or she can be able to obtain the higher value of profit than it would have been if the security had been sold at the end of its maturity. Those investors who have invested in long term securities prefer to use this strategy to ensure they employ on profit maximization and yield a lot of revenues as well for their companies and themselves.

Work Cited

Bauer, Michael D., and Thomas M. Mertens. "Economic Forecasts with the Yield Curve." FRBSF Economic Letter 7 (2018).

Berentsen, Aleksander, and Christopher Waller. "Liquidity premiums on government debt and the fiscal theory of the price level." Journal of Economic Dynamics and Control 89 (2018): 173-182.

Beer, Sebastian. "A cost-risk analysis of sovereign debt composition in CESEE." Focus on European Economic Integration Q 1 (2018): 6-25.