Liquidity Preference Theory

Liquidity Preference Theory

The hypothesis that forward rates offer a premium over expected future spot rates.

Notes:

Proponents of this theory believe that, according to the term structure of interest rates, investors are risk-averse and will demand a premium for securities with longer maturities. A premium is offered by way of greater forward rates in order to attract investors to longer-term securities. The premium received normally increases at a decreasing rate due to downward pressure from the decreasing volatility of interest rates as the term to maturity increases.

Also known as "liquidity preference hypothesis."

See also: Forward Rate, Keynesian Economics, Liquidity, Liquidity Trap, Term Structure of Interest Rates