Correct Answer: (d) Forecasts a steeper drop in future spot rates than the unbiased expectations theory.
According to the Liquidity Preference Theory, investors generally prefer short-term bonds because they are less sensitive to interest rate changes. To encourage investors to hold longer-term bonds, borrowers must offer a positive liquidity premium.
This means long-term interest rates reflect both expected future short-term interest rates and an additional liquidity premium.
For example:
Suppose the yield on a one-year bond is 5%, while the yield on a longer-term bond is 4%.
Under the Unbiased Expectations Theory, the declining yield curve suggests that investors expect future short-term interest rates to decrease.
However, under the Liquidity Preference Theory, the longer-term yield already includes a positive liquidity premium.
Therefore, for the longer-term yield to be only 4%, expected future short-term rates must be even lower than the unbiased expectations theory would suggest.
The key idea: Since the liquidity premium pushes long-term yields upward, a downward-sloping yield curve indicates an even stronger expectation of declining future interest rates.
Final Answer: (d) Forecasts a steeper drop in future spot rates than the unbiased expectations theory.
