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Subject 4. Traditional Theories of the Term Structure of Interest Rates PDF Download
Local Expectations Theory

Unbiased expectations theory

  • It suggests that the term structure of interest rates is based on investor expectations about future rates of inflation and corresponding future interest rates, assuming that the real interest rate is the same for all maturities.
  • According to the theory, forward rates exclusively represent expected future rates. Thus, the entire term structure at a given time reflects the market's current expectations of the family of future short-term rates.
  • Under this view, a rising term structure must indicate that increasing rates of inflation are expected, and the market expects short-term rates to rise throughout the relevant future. Similarly, a flat term structure reflects an expectation that future short-term rates will remain relatively constant, while a falling term structure must reflect an expectation of decreasing rates of inflation and that future short-term rates will decline steadily. For example, if the 1-year forward rate 2 years from today is 6%, the pure expectations theory states that the market expects a 6% 1-year rate in two years.

For example, if 3 months from today you want to buy a 6-month T-bill, you would look at the forward rate on the 6-month T-bill to see what its expected yield is projected to be in 3 months. Let's assume the forward rate is 1% for that specific T-bill. In this case, unbiased expectations theory would suggest that the 6-month interest rate 3 months from today will be 1%.

This theory suffers from one serious shortcoming: it says nothing about the risks inherent in investing in bonds and like instruments.

The local expectations form of the pure expectations theory recognizes that in the long term interest rate and reinvestment risks are important. In the short term these risks are ignored and investors are assumed to be indifferent between different instruments. For example, it states that the two alternative strategies mentioned above may not yield the same results, but if the investment horizon is reasonably short (i.e., 6-month), the choice of investment instrument is largely irrelevant.

Liquidity Preference Theory

Because the price volatility of a short-term investment is lower than the price volatility of a long-term investment, investors prefer to lend short term. They must be offered a risk premium to lend long-term.

Borrowers often prefer long-term bonds because they eliminate the risk of having to refinance at higher interest rates in future periods. Furthermore, the fixed costs of frequent refinancing can be quite high. Therefore, borrowers are willing to pay the premium necessary to attract long-tern financing.

Under the liquidity preference theory, long-term bonds are more risky than short-term bonds because:

  • Long-term bonds are less liquid.
  • Long-term bonds are more sensitive to changes in interest rates.
  • The longer the maturity of a bond, the greater the price volatility when interest rates change.

All else equal, rational investors will prefer the less risky, short-term bonds. Therefore, long-term bonds should always provide a maturity premium to compensate for the liquidity risk. The liquidity premium increases with maturity. Based on this theory, an upward sloping yield curve may be caused by one of the following two reasons:

  • Future interest rates will rise; or
  • Future interest rates will be unchanged or fall, but the maturity premium will increase fast enough with maturity so as to cause the yield curve to slope upward.

Flat or downward sloping yield curves are mainly caused by declining future short-term interest rates.

Market Segmentation Theory

This theory contends that the shape of the yield curve is determined by supply of and demand for securities within each maturity sector. It believes that the yield curve mirrors the investment policies of institutional investors who have different maturity preferences.

  • Banks need liquidity and prefer to invest in short-term bonds, while corporations with seasonal fund needs prefer to issue short-term bonds.
  • Life insurance companies prefer to invest in long-term bonds to match their long-term liabilities, while real estate companies prefer to issue long-term bonds due to their long project cycles.

The bond market is segmented based on the maturity preferences of investors and issuers. Within each market segment, the prevailing yields are determined by the supply and demand for the bonds. An upward sloping yield curve indicates that:

  • Supply outstrips demand for short-term bonds, causing low short-term rates.
  • Demand outstrips supply for long-term bonds, resulting in high long-term rates.

If the yield curve is flat, that means both short-term and long-term bonds are in equilibrium so interest rates are the same for all maturities. You should be able to draw similar conclusions for other types of yield curves.

This sounds very similar to the preferred habitat theory discussed below, but there is an important difference between these two. The preferred habitat theory argues that investors will shift out of their preferred maturity sectors if they are given a sufficient high maturity premium. In contrast, the market segmentation theory asserts that investors will always stick to their preferred maturity sectors.

Preferred Habitat Theory

This theory also recognizes that forward rates are biased predictors of short-term rates, but in this case the risk premiums are explained by forces of demand and supply, rather than liquidity, within a given maturity range. Lenders and borrowers are assumed to have "preferred habitat", the investment horizon for which they prefer to invest or borrow. Usually lenders prefer to invest for a short term and borrowers prefer to raise long term capital. Investors will shift out of their preferred maturity sectors if they are given a sufficient high risk premium. Similarly, borrowers ask for lower interest rates when they raise short-term capital.

The shape of the yield curve under the preferred habitat theory is explained by forward rates and risk premiums that are necessary to shift investors and lenders from their preferred habitat, so that demand and supply of funds would be in equilibrium. Any yield curve shape can be explained by this theory.

User Contributed Comments 5

User Comment
charliedba The liquidity preference theory asserts that liquidity premiums exist for long term lending, which in turn suggests that an upward sloping term structure would be expected to occur more often than a downward sloping term structure.
dmitry Market Segmentation Theory: For example, upward sloping curves mean that supply and demand intersect for short-term is at a lower rate than longer-term funds. The cause is relatively greater demand for longer-term funds or a relative greater supply of shorter-term funds.
ANdriusABJ I might be too tired but I just can not understand the presented relationship between supply/demand and rates. To my understanding if supply outstrips demand - bonds' prices are going down and the yields will he high. What am I missing?
njhpeyton Short-term bonds have relatively more demand, hence they are priced higher and earn lower returns, and vice versa for long-term bonds.
davidt87 I'm with Andrius and njhpeyton seems to agree?
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