Liquidity Premium Theory: an Empirical Support From Sukuk (Islamic Bonds) Yields and Profits Curves

Abstract

The need to account for all one-period returns on bonds which are reinvested at the coupon rate and which in turn would lead to percentage increase in the investors’ wealth over a particular investment horizon led to Liquidity Premium Theory. Sukuk (Islamic bonds with profit rates instead of coupon rates) has been found to be similar to conventional bonds and has been used to achieve same objectives, especially in meeting long term needs of lenders “lid borrowers ill the capital market. Therefore, this study examines the relationship between the yields and maturities of Sukuk to see if long term investors who currently dominate Sukuk market are obtaining term premium to compensate them for the risk involved in long term lending. Using extended Heart, Jarrow and Morton (1992) model, empirical result obtained using 2001 -2009 data on Sukuk and employing MATLAB statistical tool on spot and forward profit rates indicate that there is biased expectation by the Sukuk investor:’. The biased expectation was evidence a from the shape of the Sukuk yields and credit curves plotted. This is a plausible confirmation that there is a positive spread between yields all Sukuk. A broad battery of statistical evidences from the term structure of profit rate suggests that there is support, through Sukuk holders’ expectation, for Liquidity Preference Theory.