The liquidity premium theory (LTP) is an aspect of both the expectancy theory (ET) and the segmented markets theory (SMT). In fact, LPT is a synthesis of both ideas on bonds, maturities and their respective effects on yields. All of the above deal with how bond yields change with the time of maturity. Simply put, the longer the time to maturity, the higher the yield. LPT seeks to explain this fact.
ET is a concept that holds basic equivalence among different types of bonds. It is a simple theory: if a long term bond is higher yielding than a short term bond, then buying multiple short term bonds equaling the length of the long term bond will lead to perfectly equal results. If bond A has a two-year maturity at 10 percent, and bond B has a one-year maturity at 5 percent, then buying two one-year bonds will lead to results identical to buying one two-year bond.
Segmented Markets Theory
SMT rejects ET totally. It holds that those investing in bonds have specific preferences, especially for lower term bonds. Even more, the longer it takes for a bond to reach maturity, the more difficult it is to invest. This is because the longer the term, the more vague the predictions about future inflation or interest rate risks. Because of these radical differences in bond types -- considering their length to maturity -- SMT argues that long and short term bonds are two totally different markets.
Liquidity Premium Theory
LPT is a synthesis of both SMT and ET. It utilizes insights from both to explain the common phenomenon of long term yields being higher than short term yields. The explanation is simple: the economy needs long term bonds as well as short term ones. Investing in long term bonds is far more difficult because of uncertainty -- the longer the term, the more uncertain the outcomes. Therefore, since long term bond holders keep their money tied up longer, miss other short term opportunities and face more uncertainty, the yield is better as compensation. This is the “premium” in LPT.
LPT serves as a market mechanism to encourage equilibrium between long and short term bondholders. This theory stresses that while the two types of bond are very similar, they are not identical. LPT predicts that even if interest rates are predicted to be flat, long term bonds will still yield higher profits at the end of their term. If long term rates are expected to dip, then long term investors can expect to break even, or even make a tiny profit. LPT serves to explain how this can be.