Canadian Securities Course (CSC) Level 1 Practice Exam

How does the liquidity preference theory distinguish between short-term and long-term bonds?

1. Short-term bonds have higher liquidity risks

2. Investors preferring liquidity favor long-term bonds

3. Long-term bonds offer greater liquidity and lower risk

4. Short-term bonds are less liquid and perceived as less risky

The correct answer is: Short-term bonds are less liquid and perceived as less risky

Liquidity preference theory posits that investors have a preference for liquidity, which influences their choices between short-term and long-term bonds. According to this theory, short-term bonds are generally considered more liquid because they have shorter maturities, allowing investors to access their capital more quickly. Investors typically view short-term bonds as less risky due to their shorter exposure to interest rate fluctuations and credit risk, making them more attractive during uncertain market conditions. This perception of lower risk combined with higher liquidity makes short-term bonds a preferred option for many investors. On the other hand, long-term bonds are associated with greater interest rate risk and lower liquidity since they tie up an investor's capital for a longer duration. This distinction reinforces why investors may prefer short-term securities when they prioritize liquidity and risk management. Thus, recognizing that short-term bonds are perceived as less liquid and less risky aligns with the liquidity preference principle, underscoring their appeal to investors seeking immediate access to funds.