Question

Summarize, compare, and contrast the various theories that explain the shape of the term structure of interest rates. Which theory is most reasonable? What do researchers, academics, and practitioners, think about these various theories? Please support your answer with appropriate research.

Answer 1

There are mainly four major theories regarding term structure of interest rate namely,

1. Pure expectation theory

2. Liquidity preference theory

3.Preferred Habitat theory.

4. Market segmentation theory

1. Pure expectation theory

According to this theory, only market expectation about the future will impact the shape of the yield curve. If the short term interest rates are expected to rise, a positive yield curve appears; if the rates are expected to be stable or constant the yield curve will be flat and if the interest rates will be falling, the yield curve will be inverted. Major disadvantage of this theory is that it assumes that investors are indifferent about difference in maturities and risks associated with the instrument.

2. Liquidity preference or biased expectation theory

According to this theory investors are reluctant to long term investments due to uncertainity prevailing. They prefer short term investment to long term maturities. For bonds with longer maturity a liquidity premium is demanded by the investors. Usually a natural bias is associated therefore usually a positively sloped yield curve could be found.

3.Preferred habitat theory

According to this theory every investor has his own choice of selecting an investment which falls within his interest of years of maturity. He only crosses his comfort zone if an attractive risk premium is offered on instruments with longer maturities.this is a variation over expectation theory that according to this theory , investors do care about maturities and returns.

4. Market segmentation theory

According to this theory it is the demand and supply within a maturity sector that determines the rate of interest.thus any shape of yield curve can occur be it positive , flat , inverted or humped. An humped curve occurs when the returns are greatest in the middle than in short and long term maturities.

Liquidity preference theory explains the whole idea of the short term.inerest rates being lower than long term interest rates in the most easiest possible way. It states longer the maturity the investors need greater returns to compensate for the risk assumed.