Tuesday, May 26

Liquidity Preference Theory

Liquidity Preference Theory 

Since the previous two theories could not adequately explain the facts of the term structure of 

interest rate, a more logical way to deal with this problem is to combine the best features of both 

theories. A combination of these two theories gave rise to what is largely called the liquidity 

preference theory. 

The liquidity preference theory originated with Hicks (1939), and according to Dzigbede (2003), 

it was largely derived from the empirical experiences of the 1930s when short rates were 

significantly below the long term rates. In this era, it was assumed that this was the natural 

relationship between the short and long term rates of return. 

According to Mishkin(2010) the liquidity preference theory of the term structure states that the 

interest rate on a long-term bond will equal an average of short-term interest rates expected to 

occur over the life of the long-term bond plus a liquidity premium (also referred to as a term 

premium) that responds to supply and demand conditions for that bond. 

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The key assumption of this theory is that bonds of different maturities are substitutes but not 

perfect substitutes. Mishkin (2010) commented that since bonds of different maturities aren’t 

perfect substitutes, the expected return on one bond does influence the expected return on a bond 

of a different maturity, but it allows investors to prefer one bond maturity over another. Since the 

risk involved in holding long term bonds is high, investors must be compensated with a liquidity 

premium to encourage them to hold more long. Such an outcome would modify the expectations 

theory by adding a positive liquidity premium to the equation that describes the relationship 

between long and short-term interest rates (Mishkin, 2010). Therefore, as Dzigbede (2003) puts 

it, the liquidity preference theory is built upon the expectation theory by postulating that the 

higher interest rates is determined by two components- which are, 1) the expectations 

components and 2) the liquidity premium component. 

The above statement can be represented by the following expression as given by Mishkin (2010) 

Int = [( it+ite+1+iet+2+…+iet+(n-1) ) ÷n ] +lnt 

Where [( it+ite+1+iet+2+…+iet+(n-1) ) ÷n ] represents the expectations component and the lnt is the liquidity premium component for the n period bond at time t. according to Mishkin (2010), the 

liquidity premium term is positive and rises with the term to maturity of bonds, n. 

2.1.6 The Government Debt Security Market. (The Bonds Market) 

A bond is a contract that commits the issuer to make a definite sequence of payments until a 

specific time (Bailey, 2005 as cited in Akotia, 2012). Akotia (2012) describes a bond as long 

term securities and are often called fixed income securities because the debt service of the issuer 

is fixed. In Ghana, bonds are usually issued by the government. The type of bonds issued by the 

government are referred to as treasury bonds and are usually risk-free (Akotia, 2012). Other 

types of bonds include cooperate bonds, foreign bonds, euro bonds, municipal bonds among 

others (Akotia, 2012). 

2.1.7 Credit ratings of government bonds 

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A credit rating is an assessment of an entity’s ability to pay its financial obligations (US 

Securities and exchange Commission). An entity’s ability to pay financial obligations is referred 

to as ‘creditworthiness’ Credit ratings apply to debt securities like bonds, notes, and other debt 

instruments (such as certain asset-backed securities) and do not apply to equity securities like 

common stock and they are also are assigned to companies and government. There are a number 

of credit rating agencies and they usually differ in the scale, symbols and definition they use. 

Some of these private independent agencies are Moody’s, Standard and Poor and Fitch. 

According to Trading Economics, Standard & Poor’s credit rating for Ghana stood at B- with 

stable outlook as at October 24, 2014. Also, Moody’s credit rating for Ghana was last set at B3 

with negative outlook- that is as at September 23, 2016. However according to (Lokko, 2016) 

Moody’s, the international credit rating agency, revised the outlook on Ghana’s long term bond 

ratings from negative to stable. Fitch gave Ghana a B with a negative outlook as at March 28, 

2014

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