128 PA R T I I Financial Markets Liquidity Premium and Preferred Habitat Theories Yield Curve Interest Rate, int Liquidity Premium, lnt Expectations Theory Yield Curve 10 15 20 25 30 Years to Maturity, n FIGURE 6-5 The Relationship Between the Liquidity Premium and Preferred Habitat Theories and Expectations Theory Because the liquidity premium is always positive and grows as the term to maturity increases, the yield curve implied by the liquidity premium and preferred habitat theories is always above the yield curve implied by the expectations theory and has a steeper slope Note that the yield curve implied by the expectations theory is drawn under the scenario of unchanging future one-year interest rates APP LI CAT IO N Liquidity Premium Theory Let s suppose that the one-year interest rate over the next five years is expected to be 5%, 6%, 7%, 8%, and 9% Investors preferences for holding short-term bonds have the liquidity premiums for one-year to five-year bonds as 0%, 0.25%, 0.5%, 0.75%, and 1.0%, respectively What is the interest rate on a two-year bond and a five-year bond? Compare these findings with the answer in the previous Application dealing with the pure expectations theory Solution The interest rate on the two-year bond would be 5.75% int + i t + i et + + i et + , , i et + (n * 1) n , lnt where it + year interest rate + 5% i et + + year interest rate + 6% l 2t + liquidity premium + 0.25% n + number of years + Thus i2t + 5% , 6% , 0.25% + 5.75%