e

6.6 Review of Traditional Theories of the Term Structure of Interest Rates and their

Implications to Forward Rates and the Shape of the Yield Curve There are four traditional theories of the term structure of interest rates

  • Pure expectations theory (unbiased expectations theory)
  • Liquidity preference theory
  • Segmented markets
  • Preferred habitat theories

6.6.1 Pure expectations theory (unbiased expectations theory)

The pure expectations theory says that the forward rate is an unbiased predictor of the future spot rate.

Its broadest interpretation suggests that investors expect the return for any investment horizon to be the same.

The narrower interpretation – referred to as the local expectations theory – suggests that the return will be the same over a short-term horizon starting today (1+ZT) = [(1+Z1)(1+f1,2)… (1+fT-1,T)]1/T Under this theory, the shape of the yield curve reflects the expectation about future short-term rates.

The predictions of the unbiased expectations theory are consistent with the assumption of risk neutrality.

Because forward rates are not perfect predictors of future interest rates, the pure expectations theory neglects the risks (interest rate risk and reinvestment risk) associated with investing in Treasury securities.

Advocates of the pure expectations theory argue that forward rates are the market's consensus of future interest rates.

6.6.2 Liquidity preference theory

The liquidity preference theory makes the following assertion:

Liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term, and these premiums increase with maturity.

(1+ZT) = [(1+Z1)(1+f1,2)+L2)…(1+FT-1,T+LT)]1/T Thus, given an expectation of unchanging short-term spot rates, liquidity preference theory predicts an upward-sloping yield curve.

Althoughdownward-sloping or hump-shaped yield curves may sometimes occur, the existence of liquidity premiums implies that the yield curve will typically be upward sloping.

6.6.3 Segmented markets

The segmented markets theory assumes that market participants are either unwilling or unable to invest in anything other than securities of their preferred maturity.

It follows that the yield of securities of a particular maturity is determined entirely by the supply and demand for funds of that particular maturity.

6.6.4 Preferred habitat theories

The preferred habitat theory also assumes that many borrowers and lenders have strong preferences for particular maturities.

However, if the expected additional returns to be gained become large enough, institutions will be willing to deviate from their preferred maturities of habitats.

The preferred habitat theory is based on the realistic notion that agents and institutions will accept additional risk in return for additional expected returns.

In accepting elements of both the segmented markets theory and the unbiased expectations theory yet rejecting their extreme polar positions, the preferred habitat theory moves closer to explaining real-world phenomena.

Lesson Wrap-Up

This lesson should leave you able to explain the review of traditional theories of the term structure of interest rates and their in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain pure expectations theory (unbiased expectations theory) in your own words.
  2. Explain liquidity preference theory in your own words.
  3. Explain segmented markets in your own words.
  4. State one exam-style risk, valuation, or market implication of the review of traditional theories of the term structure of interest rates and their.