Canadian Securities Course (CSC) Level 1 Practice Exam

The idea here is that liquidity preference theory says investors value the ability to convert investments to cash easily. To hold longer-term bonds, they require a liquidity premium as compensation for reduced liquidity and greater uncertainty about future rates. So short-term bonds are favored for their higher liquidity and lower immediate risk, while long-term bonds carry more liquidity risk and price volatility with changes in interest rates.

The statements given don’t describe this correctly: short-term bonds do not have higher liquidity risks; those who want liquidity would not favor long-term bonds; and long-term bonds do not offer greater liquidity or lower risk. Therefore, none of the descriptions accurately capture how liquidity preference theory differentiates between short- and long-term bonds.