Liquidity preference

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Business Finance


How does liquidity preference theory work now?

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Explanation & Answer

The investors will sacrifice the ability to earn interest on money that they want to spend in the present, and that they want to have it on hand as a precaution. On the other hand, when interest rates increase, they become willing to hold less money for these purposes in order to secure a profit.

Liquidity Preference Theory (LPT) is a financial theory which suggests investors prefer (and hence will pay a premium) for assets which are very liquid, or alternatively will pay less than market value for very illiquid assets. This difference in price between market value and actual price represents the risk (or lack of it) associated with the liquidity of an asset.

This is clearly evidenced in the yield pricing of bonds. A bond with a longer maturity typically pays more interest than one with a short maturity and this is to entice investors to buy the less liquid, more risky asset (assuming longer-maturity bonds are harder to trade than those with a shorter maturity).

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