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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