The Risk & Term Structure of Interest Rates (Expectations Theories…
The Risk & Term Structure of Interest Rates
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.
Bond holders consider bonds with different maturities to be perfect substitutes.
Expectations theory explains:
Why the term structure of interest rates changes at different times.
Why interest rates on bonds with different maturities move together over time (fact 1).
Why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2).
Cannot explain why yield curves usually slope upward (fact 3)
Segmented Markets Theories
Bonds of different maturities are not substitutes at all.
Investors have preferences for bonds of one maturity over another.
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond.
If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3).
Liquidity Premium & Preferred Habitat Theories
Liquidity Premium Theory
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond.
Bonds of different maturities are partial (not perfect) substitutes.
Preferred Habitat Theory
Investors have a preference for bonds of one maturity over another.
They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return.
Investors are likely to prefer short-term bonds over longer-term bonds.
Interest rates on different maturity bonds move together over time; explained by the first term in the equation
Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case
Yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens