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    4 Term Structure Theory of Interest Rate

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    Husnul Iradati
    The document discusses four theories of term structure of interest rates: 1) Pure Expectation Theory which explains the yield curve based on expected short-term rates but assumes no investor preference, 2) Market Segmentation Theory which states that yields are determined by supply and demand within maturity markets, 3) Liquidity Preference Theory where investors demand higher yields on longer-term securities due to greater interest rate risk, and 4) Preferred Habitat Theory where investors prefer certain maturity lengths and require a risk premium for other maturities.

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    4 Term Structure Theory of Interest Rate

    Uploaded by

    Husnul Iradati
    104 views2 pages
    The document discusses four theories of term structure of interest rates: 1) Pure Expectation Theory which explains the yield curve based on expected short-term rates but assumes no investor preference, 2) Market Segmentation Theory which states that yields are determined by supply and demand within maturity markets, 3) Liquidity Preference Theory where investors demand higher yields on longer-term securities due to greater interest rate risk, and 4) Preferred Habitat Theory where investors prefer certain maturity lengths and require a risk premium for other maturities.

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    4 Term Structure Theory of Interest Rate

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    The document discusses four theories of term structure of interest rates: 1) Pure Expectation Theory which explains the yield curve based on expected short-term rates but assumes no investor preference, 2) Market Segmentation Theory which states that yields are determined by supply and demand within maturity markets, 3) Liquidity Preference Theory where investors demand higher yields on longer-term securities due to greater interest rate risk, and 4) Preferred Habitat Theory where investors prefer certain maturity lengths and require a risk premium for other maturities.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    104 views2 pages

    4 Term Structure Theory of Interest Rate

    Uploaded by

    Husnul Iradati
    The document discusses four theories of term structure of interest rates: 1) Pure Expectation Theory which explains the yield curve based on expected short-term rates but assumes no investor preference, 2) Market Segmentation Theory which states that yields are determined by supply and demand within maturity markets, 3) Liquidity Preference Theory where investors demand higher yields on longer-term securities due to greater interest rate risk, and 4) Preferred Habitat Theory where investors prefer certain maturity lengths and require a risk premium for other maturities.

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    4 Term Structure Theory of Interest Rate

    Pure Expectation Theory


    The theory explains the yield curve in terms of expected short-term rates.
    It is based on the idea that the two-year yield is equal to a one-year bond
    today plus the expected return on a one-year bond purchased one year
    from today. The one weakness of this theory is that it assumes that
    investors have no preference when it comes to different maturities and
    the risks associated with them.
    Market Segmentation Theory
    The major conclusion drawn from market segmentation theory and
    applied to investing is that yield curves are determined by supply and
    demand forces within each separate market, or category, of debt security
    maturities, and that the yields for one category of maturities cannot be
    used to predict the yields for securities within a different maturity market.
    Market segmentation theory is also known as the segmented markets
    theory. It is based on the belief that the market for each segment of bond
    maturities is largely populated by investors with a particular preference
    for investing in securities within that maturity time frame short-term,
    intermediate-term or long-term.
    Liquidity Preference Theory
    This theory states that investors want to be compensated for interest rate
    risk that is associated with long-term issues. Because of the longer
    maturity, there is a greater price volatility associated with these
    securities. The structure is determined by the future expectations of rates
    and the yield premium for interest-rate risk. Because interest-rate risk
    increases with maturity, the yield premium will also increase with
    maturity. The liquidity preference theory suggests that an investor
    demands a higher interest rate, or premium, on securities with long-term
    maturities, which carry greater risk, because all other factors being equal,
    investors prefer cash or other highly liquid holdings. According to the
    liquidity preference theory, interest rates on short-term securities are
    lower because investors are sacrificing less liquidity than they do by
    investing in medium-term or long-term securities.
    Preferred Habitat Theory
    A term structure theory suggesting that different bond investors prefer
    one maturity length over another and are only willing to buy bonds
    outside of their maturity preference if a risk premium for the maturity
    range is available. The theory also suggests that when all else is equal
    investors prefer to hold short-term bonds in place of long-term bonds and
    that the yields on longer term bonds should be higher than shorter term
    bonds.

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