Question

If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?

Short answer

We can infer from the flat yield curve that short-term interest rates are likely to fall or vary marginally in the future.

Step-by-step solution

Definition

Expectations theory says that outcomes do not differ regularly or are predictable from what people expected them to be. It entails that the interest rate on a long-term bond will be equal to the average of the expected short-term interest rates over the life of the long-term bond.

Explanation

The expectations theory can help explain the influence of flat yeild curves on the liquitdity premiums.. The liquidity premium for the flat yield curve will moderately fall in near future.

So the expectations theory could explain why the bonds with different maturities have minor variations in their interest rates over time. This also explains the upward slope of the yield curve at lower interest rates and a downward slope of it when the interest rates are higher. A Typical upward sloped yield curve implies that the short-term interest rates will rise over time; in contrast, the short-term interest rates are most likely to fall over time in the future.