What does liquidity preference theory suggest?

Liquidity preference theory suggests that investors demand a premium for longer-term securities due to the increased risks associated with holding these assets over time. This theory is rooted in the concept that because longer-term investments are subject to more uncertainties—such as changes in interest rates, inflation, and potential credit risks—investors require additional compensation for taking on these risks.

As such, the liquidity preference theory highlights how investors favor shorter-term securities, which are generally perceived as less risky and more liquid. This preference for liquidity leads to the higher yields typically associated with longer-term securities, as investors expect to be compensated with a premium for extending their investment horizon. This dynamic is critical in understanding the yield curve, which often slopes upward, reflecting the relationship between time and the risk premium demanded by investors for longer maturities.

In summary, liquidity preference theory explains why longer-term securities offer higher returns, as investors require compensation for the associated risks and lack of liquidity inherent in holding such assets.