 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at the liquidity preference theory in explaining the yield curve. This topic is covered on the CPA, BEC section, as well as the CFA exam, and in essentials or principles of investment course. As always, I'm gonna remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,800 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people. Check out my website, farhadlectures.com, for additional resources for this course as well as your other courses. So let's take a look first at the yield curve. What is the yield curve? It's a graphical relationship between the yield to maturity on the government bonds and the term to maturity and time. This is called the yield curve. And the yield curve could take many forms. The most common form is the rising yield curve right here. But there are other forms to the yield curve, such as an inverted yield curve. What does it mean rising yield curve versus an inverted yield curve? Because in a sense, they're the opposite of each other. Rising yield curve means short-term borrowing. Notice here, we have one month, three month, six month, then this is one year. So notice the rate here, the rate is on the y-axis and the time is on the x-axis. For less than a year, the rate is very low. It's not 0%, but it's close to 0%, less than 1%. Then when it comes one year, two year, three years, notice the rate will start to rise. So this is basically called a rising yield curve. It means short-term borrowing will cost the government more than long-term borrowing. And basically in this session, we will explain one theory why that's the case. Then we have the inverted yield curve. The inverted yield curve basically state that short-term borrowing for three months is higher than long-term borrowing for 30 years. Now, when this happens, when the government, when they need to borrow money and short-term borrowing went up versus long-term borrowing, usually from an economical perspective, that this signal will proceed six months before a recession when that happened. Again, those yield curves, they have to be interpreted in their economic, historical economic environment. We're not gonna get into this topic here. Just wanna let you know that the yield curve could take many forms. Here, the yield curve is humped. It goes started up and it goes down. Here, it's almost straight. Notice this is January 206. This is October 4th, 1989. But most of the time, the yield curve is arising. Most of the time, it's arising yield curve. Or this is what you would expect to, this is what you should expect from the yield curve. Now, in the prior session, we looked at the expectation theory to kind of predict the yield curve. It starts with the assertion that bonds are priced. So buy and hold investment in the long-term bonds provide the same results as rolling over a series of short-term bonds. This is what we covered in the prior session and we said if you have a bond, a two-year bond and the two-year bond is paying 8% year one, 8% year two and another three-year bond paying 8% year one, 9% year two and 10% year three. So if these are two separate investments, this is bond A and this is bond B. If we know bond B, which is the third year, we can predict bond A, third year rate. We can predict this by finding out how much it will cost us if we roll over this investments at 8% than at 8%. And what should we earn the third year that will equal to the bond B? And this is basically called the expectation theory. So we can basically predict the future rate based on the expectation theory. What are similar bonds for the long-term R trading? Now, although we don't assume that long-term and short-term have the same risk, but we can do this prediction. In this session, we're gonna look at another interpretation and if you want to look at the expectation theory, please look at the prior session. So according to the liquidity preference theory, forward rates, now how do we predict forward rates? Forward rates, this is what we're gonna say, will exceed the market expectation of future interest rate. Whatever you think about the future interest rate, the forward rate should exceed it. Exceed it means should be higher. Remember, exceed it means it should be higher. Now, even if the rates are expected to stay the same, we always assume the future rate will be higher. Even the rates are expected to remain the same. Let's assume in your expectation, the rate will stay 8%, 8%, 8%, 8%. Guess what? Because we are going into the future, we have to add something, we have to add something to the rate, therefore the slope would be upward, upward sloping. Now why? Now why do we say this? Why do we say this? Because Borrowers, if you think about it, and let's talk about it, not think about it too, Borrowers will prefer to issue long-term bonds. Think about it, if you are a company or if you are the government, that doesn't matter, the company or the government, if you borrow money, if you can lock your rate for a longer period of time, you will prefer to do so. This would allow you to lock an interest rate for a long period of time. Therefore, if you want to lock your interest rate for a long period of time, you may want to pay a premium, you'll be willing to pay more for those bonds. If you want to lock your bond for five or seven years, if you're borrowing, and you want to borrow for 10 years, you have to pay a premium because you're getting that advantage, because you don't have to worry about interest rate for the next 10 years, so you pay premium for that. Now the bond buyers, the people who are buying your bond, the lenders, they're gonna demand a higher rate on longer term bonds because the bond issuers are willing to pay higher rates for those bonds. Why are they willing to pay higher rate? Because they want to lock, they want that peace of mind. Well, if they want that peace of mind, if I'm the lender, I'm gonna make them pay premium for that. And this is the idea behind the liquidity preference premium. If you want to borrow for a long term, I'm okay with that. Pay me a premium and I will give you that peace of mind. So as a result, that extra premium yield a curve that to generally upward slope. So the curve will slope upward like this one, like this one. So simply put, the liquidity preference theory state that investors demand risk premium on long term bond. Why? Because if the borrower wants a peace of mind, they're gonna have to pay for that liquidity, okay? So we can think of the liquidity premium as a result from extra compensation investors demand for holding longer term bond with a greater risk. You want the peace of mind, compensate me for that, okay? So we measure it, we measure this risk as the spread between the forward rate of interest rate and the expected short term rate. Whatever that expected short term rate is, you're gonna add to it a liquidity premium, whether it's gonna go up or down in the short term, add to it liquidity premium. Therefore it should be higher to whatever you are expecting. So the forward rate will be higher than your expected rate because you are demanding that extra premium. So suppose that short term rate interest is currently at 8% and that investors expected to remain at 8% next year. So it's 8% this year, 8% next year. In the absence of a liquidity premium and no expectation of change in the yield, the yield to maturity on the two year bond would also be 8%. So if it's this year 8% and next year it's gonna be 8% on a two year bond, well, next year it means whether I buy this investment B which is for two years, if it's gonna be 8% two years or I buy investment A at 8%, then next year I would reinvest my money and it's gonna be 8%. It doesn't matter whether I take this investments or this investments, overall I'm gonna be earning per year 8%. If that's the case, the investor who wants to buy B, let me go back and put B in. This is investment B, 8%, 8% and we said A is 8%. Under the expectation theory, under the expectation theory, the other theory this will be 8%. So the missing interest rate based on the expectation it will be 8% which is investment A. Now under the liquidity preference theory, investors will demand risk premium to invest in B. They will not accept B to be 8% for two years. Why? Because you are locking your money for two years. So if the liquidity premium is 1%, let's assume the liquidity premium is 1%, then the forward rate will be 8 plus one equal to nine. Simply put, it means for investment B you will not accept 8% and 8% because investment A will give you 8% for year one, then you will have that money to reinvest again. If you're gonna lock your money for two periods, you want to earn something above 8% and here we said risk premium is 1%. So how do we compute exactly the rate? Well, if the risk premium is 9%, it means year two should be around nine. So what should be the overall rate around 8.5? But let's see how we compute this. So we're gonna take one plus year two, which is we don't know the rate raised to the second power, which is equal 1.08 times, which is the rate for year one times 1.09, because remember it's one plus eight plus one, which is 9%, will give us 1.172. Well, we find the rate if you square root it, then we subtract one. So overall year two should be 8.5. Again, this tells you that you have to pay extra premium because you are buying the two year bond. Why are you paying 8.5? Well, again, the 8% bond, you will not pay 8%. You want a premium because you're locking your money for two years. For A, you're locking the money for one year, you're okay with eight, you are okay with 8%. But for B, because you're locking your money, you want a premium because you're locking your money for two years. And this is how you compute that extra rate. So year two should be 8.5. And if it's 8.5, if it's eight for year one, 8.5 for year two, notice here, if we graph it, it's gonna be eight, then 8.5. So it's gonna be, so if this is, sorry, this is year one, and this is year two, this is eight, and this is 8.5. So it's gonna be an upward sloping. And if you want to invest your money for a third year, then obviously you're gonna need the premium, you're gonna need to be compensated for an extra return. And this is basically, in a nutshell, the liquidity preference theory and how it explains the yield curve. If you like this recording, please like it and share it. And don't forget to visit my website for additional resources, farhatlectures.com. Good luck and study hard.