Profitability and the Time-Varying Liquidity Premium in the Term Structure of Interest Rates

There have been numerous empirical studies of the term structure. Broadly, the evidence may be said to be consistent with some influence from expectations plus the existence of a liquidity premium. Long rates or the spread between long and short rates have seemed to be systematically related to expectations of future rates, though the expectations embodied in long rates or the spread are biased upwards as the liquidity preference theory would predict. The degree of influence of expectations and the behavior of the liquidity premium, however, have remained matters of controversy. In several recent studies (e.g., Robert Shillert 1979; Shiller, John Campbell, and Kermit Schoenholtz, 1983; David Jones and Vance Roley, 1983; Mankiw and Summers, 1984; and Mankiw, 1986) the expectations theory has performed poorly, even allowing for the existence of a constant liquidity premium, in attempts to test the joint hypothesis of rational expectations and the expectations theory. Shiller, Campbell, and Schoenholtz and Mankiw and Summers, among others, have suggested renewing the search for the determinants of a time-varying liquidity premium as a possibility for explaining what is going on but have had little success themselves in finding such.