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interest payments and earnings volatility. To encourage lenders to invest in bonds with maturities longer than
their intended holding periods and face uncertain HPR, issuers must satisfy the demand for liquidity premium
– a premium associated with investing in an n + t period bond for t periods. The liquidity premium is
incorporated into the forward rate by: f(n,t) = E[r(n,t)] + E(LP(n,t)].
Under LPT, E[r(1,1)] cannot have the same value of f(1,1). Otherwise, 2 alternative investments will end up
with 1 HPR. Expected = Forward Rate – Liquidity Premium. The lower market expected rate means a higher
selling price and hence a larger holding period return can be expected from the latter investment to
compensate investors for accepting the additional risk.
Liquidity premium is related to the risk of uncertain selling prices, when investors purchase bonds with
maturities longer than their intended holding period, and not to the risk of uncertain coupon reinvestment
incomes. There is a difference in HPR compared to an investment that is has a maturity = to investor’s
intended holding period return. This difference arises from the need to sell bond before they mature at future
Forecasts errors may exist. If actual interest rates are larger than the expected rate, then the selling price and
HPR will be lower than expected. However, as long as the forecast errors is less than the liquidity premium, the
actual return obtained from investing in a longer maturity bond will be higher than a shorter maturity bond.
Factors that affect liquidity premium are number of periods to maturity, and the timing of the forecast. The
larger the number of periods to maturity and the later the forecast, the more risky the investment, hence the
higher the liquidity premium.
According to LPT, both the liquidity premiums and market expectations play a role in driving the shape and
level of the yield curve. Under LPT, an upward sloping yield curve does not necessarily imply...
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