Question

explain the three main theories that attempt to explain thr nature of the yield

Answer 1

The three theories regarding yield are:-

1. Pure expectations theory: The yield curve shape is the reflection of the investors belief about the interest rates in short term future. Since most of the investors expect that the interest rates would rise, so the shape of the curve is upward sloping.

2. Preference for Liquidity: This is also a variant of the Pure expectations theory. It states that the investors include a premium for holding the bonds of longer term nature. Thus due to the uncertainty regarding price of bond for a longer duration, the longer duration bonds have to be given a yield premium and this explains the upward sloping of the yield curve.

3. Preferred habitat theory: This theory states that all investors have a specific investing horizons and therefore need a premium to hold bonds of longer maturities, since most investors want short term bonds. Thus the longer maturies bond need a premium which explains the yield curve.