James Chen, CMT is an professional trader, invest adviser, and global market strategist. He has authored publications on technical analysis and international exchange trading published by john Wiley and Sons and served as a guest expert on CNBC, BloombergTV, Forbes, and also Reuters among other jae won media." data-inline-tooltip="true">James Chen

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What Is Liquidity preference Theory?

Liquidity preference Theory is a version that suggests that an investor should need a greater interest price or premium top top securities with long-term maturities that carry greater hazard because, every other determinants being equal, investors favor cash or other extremely liquidholdings.

Liquidity choice Theory describes money demand as measured with liquidity.John Maynard Keynes stated the ide in his publication The basic Theory the Employment, Interest, and also Money (1936), stating the connection between interest rates and also supply-demand.In real-world terms, the much more quickly an asset can be converted right into currency, the more liquid that becomes.

just how Does Liquidity choice Theory Work?

Liquidity preference Theorysuggests that investors need progressively greater premiums on medium and long-term securities together opposed to temporary securities. According to the theory, which was emerged by man Maynard Keynes in support of his idea the the need for liquidity holds speculative power, fluid investments are simpler to cash in for full value.

Cash is commonly accepted together the most liquid asset. According to the liquidity preference theory, interest prices on short-lived securities space lower because investors space not sacrificing liquidity for better time frames than medium or longer-term securities. 

one-of-a-kind Considerations

Keynes introduced Liquidity preference Theory in his book The general Theory that Employment, Interest and also Money. Keynes defines the concept in terms of three engine that identify the need for liquidity:

The transactions motive says that individuals have actually a choice for liquidity to insurance having adequate cash top top hand for simple day-to-day needs. In various other words, stakeholders have actually a high demand for liquidity come cover their momentary obligations, such together buying groceries and also paying the rental or mortgage. Greater costs the living typical a higher demand for cash/liquidity to satisfy those day-to-day needs. The precautionary motive relates come an individual's preference for additional liquidity if one unexpected difficulty or price arises that calls for a considerable outlay the cash. This events include unforeseen costs like residence or automobile repairs.Stakeholders may also have a speculative motive. When interest rates space low, demand for cash is high and also they may prefer to hold assets till interest rates rise. The dangerous motive describes an investor's reluctance to tying up investment funding for fear of missing out ~ above a far better opportunity in the future.

When greater interest rates are offered, investors offer up liquidity in exchange for higher rates. As an example, if interest prices are rising and also bond prices room falling, an investor may sell your low payment bonds and also buy higher-paying bonds or organize onto the cash and wait because that an even better rate the return.

example of Liquidity preference Theory

A three-year Treasury note could pay a 2% attention rate, a 10-year treasury note can pay a 4% interest rate and a 30-year treasury bond could pay a 6% attention rate. Because that the investor come sacrifice liquidity, they need to receive a higher rate that return in exchange because that agreeing to have actually the cash bound up for a longer duration of time.

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