Discuss three basic theories of the term structure.
1. Expectations Theory:
The expectation theory suggests that longer-maturity yields are a function of the current IR and expected IR.
For example, under this theory an investor is indifferent between the yield on a six-month bill and a series of two consecutive three-month investments.
Thus, with this theory, a multi-period rate can be written in terms of a series of one-period rates consisting of the current one-period rate and the series one-period expected future rates.
2. Liquidity Premium Theory:
In this theory an additional term is added to compensate short-term investor for holding a security with a term to maturity that does not match the investor’s preferred investment horizon.
In this theory it is assumed the majority of investors require the shorter term bonds and thus the longer term yields exhibit a liquidity premium, which tends to increase the longer the time to maturity.
Thus, to attract a one-month investor to invest in a two-month security, the two-month security rate must be set above the rate suggested by expectations theory.
3. Segmented Market Theory:
The segmented market theory is consistent with the observed concentration of investors in particular segments of the term structure. Risk aversion results in market participants only operating at that position on the yield curve that most suit their business needs.
This grouping of participants could lead to quite separate markets operating at different positions on the yield curve with substantial risk premiums required to encourage participants to move out of their optimal segment of the market.
The use of the yield curve for forecasting purposes is limited in this model as expected future yields may bear little resemblance to the relationship between currently observed yields suggested by the expectations hypothesis.
4. (Preferred Habitat Theory):
In this theory, participants match asset life and liability life to establish the lowest possible risk position.
A substantial premium may be required to encourage participants to invest in other than the preferred habitat, and so this premium tends to be greatest where negative demand is least.