Economics: Briefing on Different Concepts in Finance

592 Words Jan 14th, 2018 2 Pages
Both financial and psychological factors affect the behavior of investors and the marketplace. For example, one popular theory known as expectations theory is based upon the "hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today" (Expectations theory, 2012, Investopedia). In other words, a certain consistency is assumed regarding rates, even though many analysts have noted that this simple and elegant theory is often inaccurate and tends to overstate gains (Expectations theory, 2012, Investopedia).
Expectations theory relates to how short-term securities behave regarding interest rates. However, regarding long-term rates, the dominant theory to explain investor behavior is liquidity theory. This is based on the notion that people prefer to have liquid assets they can use easily, and it is necessary to compensate them with higher interest rates for long-term investment instruments, such as CDs. "Investors demand a premium for securities with longer maturities, which entail greater risk, because they would prefer to hold cash, which entails less risk. The more liquid…

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