How does liquidity premium affect interest rate?
The liquidity premium leads to a modification of uncovered interest rate parity (UIP), which enables the model to explain an appreciation of the dollar subsequent to an increase in US interest rates if foreign interest rates follow the US monetary policy rate.
What is the liquidity premium theory of the term structure of interest rates?
• Liquidity premium theory asserts that bondholders greatly prefer to hold. short-term bonds rather than long-term bonds. Short-term bonds have. less interest rate risk than long-term bonds, because their prices change. less for a given changes in interest rates.
How do you calculate liquidity premium?
The easiest way to gauge liquidity premiums is to simply calculate the yield curve, or realized return, of two investments with different levels of liquidity. Assume, for example, that two bonds have the same initial investment and the same growth rate.
Who pays liquidity premium?
This additional benefit in your investment returns is known as the liquidity premium. The graphical representation above shows that one can provide this premium if the bond holds for a longer maturity period. This premium gets paid to the investor only on the maturity of the bond held.