We discussed three different theories of yield curve determination in class. Identify and explain each type.

Expert Solution

The three different theories of yield curve determination are:-

1. Expectation Theory - This theory states that rise in short-term interest rates creates a positive yield curve and vice versa. A positive shape of yield curve indicates interest rates to increase, flat curve indicates interest rates are expected to change and negative shape of yield curve indicates falling interest rates.

2. Liquidity preference hypothesis - This theory states that investors always chose the high liquidity of short term debt and hence deviating from positive yield curve will be temporary. This theory is biased towards positively yield curve.

3. Segmented market hypothesis - This theory states that different investors rely on few maturity segments which makes the yield curve reflecting current investment policies. The yield curve is determined depending on the demand and supply at different maturities.

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