Question

Explain the three theories of the term structure of interest rate in investment management

Answer 1

Following are the major theories of the term structure of interest rates :-

1. Pure Expectations Theory : This theory states that yield curve shape is impacted only by market expectations for future interest rates. An upward sloping curve indicates that interest rates will increase in the future. A flat curve signals that interest rates are expected to remain same, and an inverted yield curve points that Interest rates will fall in the future.
2. Liquidity Preference Theory: This theory states that Investors prefer short term bonds to long term bonds because of the increased uncertainty associated with a longer time horizon. Therefore, Investors demand a liquidity premium for longer dated bonds.
3. Market Segmentation Theory: This theory assumes that borrowers and lenders live in different sections of the yield curve which is dependent upon their need to match assets with liabilities. Hence, the yield curve shape is determined by supply and demand at different maturities.