Question

Explain how the Expectation Theory and the Market Segmentation Theory explain the behavior of the yield curve according to the economic cycle.

Reference: 11th edition Financial Markets and Institutions by Jeff Madura, Chapter 3

Answer 1

Segmented Markets Theory

This theory assumes that markets for bonds of different maturities are completely separated and segmented. The interest rate for each maturity bond is determined by the supply and demand for that maturity bond only. It assumes that borrowers have particular periods for which they want to borrow and lenders have particular holding periods in mind, e.g. saving for retirement, paying for your kid's college education.

The yield curve slopes upward because the demand for short-term bonds is relatively higher than the demand for longer-term bonds. People prefer to lend for short periods of time.

The segmented markets theory cannot explain why interest rates on bonds of different maturities tend to move together since the interest rate for each maturity bond is determined by the supply and demand for that maturity bond only.

Expectations Theory

Expectations theory assumes that bonds of all maturities are perfect substitutes. Lenders and borrowers are indifferent between, say, a 2-year bond and a succession of 1-year bonds.

So, for example, if people expect that short-term interest rates will be 10% on average over the next two years, then the interest rate on 2-year bonds will be 10% too.

Let i1t = interest rate for this year on a 1-year bond
ie1,t+1 = next year's expected interest rate on a 1 year bond
i2t = today's interest rate on a 2-year bond

If i1t = 8% and ie1,t+1 = 12%, then i2t = (i1t + ie1,t+1)/2 = (8 + 12)/2 = 10%.

Suppose a 2-year bond had an interest rate above 10%, say, 11%. A 2-year bond would bring the lender a total return of 22% over the two years while a succession of two 1-year loans would only bring a 20% return. Investors will shift to the 2-year bond market and drive down the interest rate to 10%.

in,t = {i1t + ie1,t+1 + ... + ie1,t+n-1}/n

• can explain movements together by short-term and long-term interest rates since long-term rates are simply an average of short-term rates

The expectations theory predicts that the yield curve is upward sloping when interest rates are expected to rise. (Remember that yield curves generally slope upwards in the real world.) For example, suppose i2t = 6% and i1t = 4%. What must ie1,t+1 (what we now expect next year's 1-year rate to be) equal?

Yield curves are usually upward sloping, but short-term interest rates are as likely to fall as to rise. So, this prediction of the expectations theory is inconsistent with the real world evidence. It cannot explain the usual upward slope of the yield curve.

Yield Curve

The term structure of interest rates is the variation in yield for related debt instruments differing in maturity. It looks at bonds with common default risk, liquidity, information costs, and taxation characteristics but with different maturities.

The yield curve shows the relationship at any one instant between the yield to maturity and term to maturity on otherwise comparable bonds.

yield curve generally slopes upward: long-term interest rates are usually higher than short-term rates yield curve typically shifts up or down rather than twisting: long and short-term interest rates generally move up and down together