Question

1. Compare and contrast the expectations, liquidity premium, market segmentation, and preferred habitat theories of interest rates.

Answer 1

Answer-

Expectations theory

Unbiased or Pure expectations theory suggests that foreward rates are slely a result of futurespot rates and all the maturity strategies have same expected return over a given investmenr horizon. The long term interest rates are  equal to the mean of future expected short term rates.

The crux of this theory is risk neutrality where the investors do not demand a risk premium for maturity strategies that differ from their investment horizon.

Local expectations theory is similar to the above Unbiased or pure expetations theory with the diffeence that this theory follows the risk neutraity only for short holding periods and for longer holding periods risk premiums exist.

Liquidity preference theory

This theory addresses the drawbacks of the unbiased or pure expectations theory by proposing that forward rates reflect investors expectations of future spot rates and a liquiddity premium for compensating the interest rate risk and the liquidity is directly proportional to the marturity.

This theory states that foorward rates are biased estimates of market expectations of future rates as the liquidity premium is incorporated in it. The liquidity premium may be higher during economic uncertainity when investors are risk averse.

Segmented market theory

In this theory the yields are not a function of expected spot rates and liquidity premiums. The shape of yield curve is determined by borrowers and lenders who are key drivers of supply and demand of loans with varying maurities. The yield at each maturity is evaluated independently of the yields of other maturities.

Preferred Habitat theory

This theory proposes that forward rates represent expected future spot rates plus a premium but it does not support the view of the premium's relation with maturity. It suggests that that the imbalance between the supply and demand for funds in a specified matuity will push the lenders and borrowers to shift from their preferred habitat maturity to the opposite imbalance. The premium are related to supply and demand for funds at various maturities.