Premium Hypothesis

The liquidity premium hypothesis, which has been described in Hicks (1946), builds on the insight that borrowers prefer to borrow long and lenders to lend short. It states that current forward rates differ from future spot rates by a liquidity premium. This is expressed formally as (3-40). 

Expression (3.40) states that the forward rate ft T,T -l-l) is the expected one-period spot rate at time 77 rate given by plus the liquidity premium, which is a function of the maturity of the bond (or the term of the loan). This premium reflects the conflicting requirements of borrowers and lenders traders and speculators will borrow short and lend long in an effort to earn the premium. 

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Predict When you apply a hypothesis to a specific situation, you predict something about that situation. A prediction makes a statement in advance, based on prior observation, experience, or scientific reasoning. People use predictions to make everyday decisions. Scientists test predictions by performing investigations. Based on previous observations and experiences, you might form a prediction that cars are more efficient with premium gasoline. The prediction can be tested in an investigation. 

Dhillon, U., Lasser, D., 1998. Term premium estimates from zero-coupon bonds new evidence on the expectations hypothesis. J. Fixed Income 8, 52-58. 

One important study in this tradition avoids this problem. Moore and Viscusi (1989) relate benefit levels not to lost-time injury claims but to fatality rates. The reporting of fatalities is presumably not affected by the level of benefits and consequently, they argue, any relationship can be assumed to reflect safety incentive effects rather than reporting effects. The authors in fact find a strong negative relationship between benefit (and hence premium) levels on the one hand and fatality rates on the other, thus lending support to the hypothesis that experience rating works to make employers more safety conscious. 

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