Which of the following are valid reasons that explain an upward sloping yield curve?
1. The market expects interest rates to increase in the future
II. The market expects interest rates to decline in the future
III. Investors prize liquidity over illiquidity
IV. Investors believe the economy is likely to enter recession
There are two main theories that explain an upward sloping yield curve. The first is the market expectations hypothesis (called 'pure expectations'). According to this explanation, the yield curve represents investor expectations of future yields, and forward rates are predictors of future interest rates. The yield curve slopes upwards when investors expect interest rates to go up in the future. Thus, statement I is correct. By the same logic, statement II is incorrect.
The second explanation for an upward sloping yield curve is the liquidity preference theory - according to which investors value liquidity and are prepared to pay more for instruments that mature earlier. Having their money tied up in longer maturity instruments increases all kinds of risks, and therefore longer term instruments are priced lower than instruments maturing earlier. Since the price of instruments that mature earlier is higher, their yield is lower than that of longer dated securities, thereby leading to an upward sloping yield curve. Therefore statement III is correct.
Statement IV actually explains why an yield curve may be downward sloping - in fact an inverted yield curve is considered an indicator of an upcoming recession. Therefore statement IV does not explain an upward sloping yield curve, and is therefore not a correct choice for the answer.
Thus statements I and III correctly explain an upward sloping yield curve. Other choices are incorrect.