Chapter 6 presents two theories regarding the term structure of interest rates; the unbiased expectations theory (UET), and the liquidity premium theory (LPT). Which do you find more plausible and why?

My original response:

Unbiased Expectations Theory or Expectations hypothesis Theory or Pure Expectation Theory states that long-term interest rates hold a forecast for short-term interest rates in the future. The theory suggests that an investor earns the same amount of interest by investing in a one-year bond in the present and rolling the investment into a different one-year bond after one year as compared to purchasing a two-year bond in the present.

For example, suppose one-year interest rate over the next five years are expected to be: 5%, 6%, 7%, 8% and 9%

Then, interest rate on the two-year bond:

(5% + 6%)/2 = 5. 5%

Interest rate on the five-year bond:

(5% + 6% + 7% + 8% + 9%)/5 = 7%

Interest rates on one to five-year bonds:

5%, 5.5%, 6%, 6.5%, and 7%

In conclusion, the interest rate on a long-term bond will equal average of the short-term interest rates that people expect to occur over the life of the long-term bond.

The Liquidity Premium Theory assumes bonds of different maturities are substitutes, but not perfect substitutes. The interest rate on a long-term bond will equal the average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond. Bonds with longer maturities have a tendency to to have higher yields. Although illiquidity is a risk itself, considered under the liquidity premium theory are the other risks associated with long-term bonds: notably interest rate risk and inflation risk. Increased risks will lower demand for these bonds, in turn, increasing their yield. This increase in yield is the risk premium to compensate the buyer of long-term bonds for their increased risk.

A bonds yield can be divided into a risk-free yield and the risk premium. The risk-free yield is the yield calculated by the formula for the expectation hypothesis. The risk premium is the liquidity premium that increases with the term of the bond. Therefore, the yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little, and so the liquidity premium theory of the term structure of interest rates explains the generally upward sloping yield curve for bonds of different maturities.

The Liquidity premium theory is more plausible than the Unbiased expectations theory because it explains the return or yield on the basis of the risk involves in the taking the bonds. The longer the expiration, the larger the risk, so larger the return or yield. On the other hand, unbiased expectations theory aligns the interest rates by equating the two different period bonds. It does not specify the reason of different interest rates of two bonds. The character of bonds has been explained by the Liquidity premium theory.

Feedback Given:

Interesting comments! Some I agree with, some I don't - I'll let others weigh in before commenting too much. One item of note, your comment " The risk-free yield is the yield calculated by the formula for the expectation hypothesis. The risk premium is the liquidity premium that increases with the term of the bond." Under the expectation hypothesis, there are many risks incorporated (interest rate risk, inflation risk, default risk, etc.) just not liquidity risk. So it is not a risk free yield!

Please provide some insight, so that I may better understand and be able to provide good feedback response.