I'm working with the following task:
"You are convinced that the bond market is dominated by long-term investors. Hence, you have your own view on the liquidity premium/discount that forward rates embody. Given that, do you think that a duration of 3 years for this portfolio is a good idea or a duration of -3 years would be better?" (The provided yield-curve is upward sloping).
First, liquidity discount and premium are in contrast to each other?
Second, could anyone explain why/if the forward rates embody a liquidity discount because the market is dominated by long-term investors?
What does it involve if the forward rates embody a liquidity discount, and what will this imply for the future expected rates?
This is the solution, but it doesnt make much sense to me:
"Market dominated by long-term investors ⇒ Liquidity discount ⇒ E[r] > f Upward sloping yield curve ⇒ f > y0 In other words, forward rates above current yields. And, on top of that, we need to take into account the liquidity discount to obtain the expected short rates. Hence, future interest rates are expected to increase and, thus, one would prefer a portfolio with a duration of -3."