Difference Between Expectation Hypothesis and Liquidity Preference

Question 16

What is the difference between the expectations hypothesis and liquidity preference theory interpretation of the term structure of interest rates?

The differences between the two term-structure of interest rate models, expectations hypothesis and liquidity preference theory, are hard to miss. Under the expectation hypothesis, the term structure of interest rate is said to reflect the market expectation of future short-term rates meaning that bonds with different maturity would be equivalent to a series of one period bonds. The hypothesis was based on the assumption that bonds with different maturity are perfect substitutes as expected excess returns and yield term premium are constant over time. On the other hand, the liquidity preference theory states that forward rate would be higher than the expected future rate as the forward rate would have taken liquidity premiums for longer term bonds into account. As the maturity of a bond increases, the liquidity premium also increases due to higher risk associated with longer term. Hence, the difference stems from the fact that liquidity premium takes risk into account while expectation hypothesis do not.

With this contradiction, the interpretation would also differ. When expected short rates are increasing, the yield curve of the expectation hypothesis would be upward sloping to coincide with the higher expectations. Similarly, the yield curve for liquidity premium theory would also be upward sloping but its slope would be steeper than the yield curve for expectation theory because of liquidity premium presence. Conversely, if short rates were expected to decline, the expectation hypothesis would have a yield curve that is downward sloping. However, the yield curve in the liquidity premium theory would still be upward sloping if the liquidity premium exceeds the decline in short rate but if the opposite is true, the yield curve would be downward sloping and is relatively flatter than the expectation hypothesis’ yield curve.