Page 20 - PowerPoint Presentation

LOS 34.j: Explain traditional theories of the term READING 34: THE TERM STRUCTURE AND
structure of interest rates and describe the INTEREST RATE DYNAMICS
implications of each theory for forward rates and MODULE 34.5: TERM STRUCTURE THEORY
the shape of the yield curve.

Local Expectations Theory: Agrees with risk-neutrality proposition but requires this is only true for short holding periods: long-
term, risk premiums abound! Over short time periods, every bond (even long-maturity risky bonds) should earn the risk-free rate.

Doesn’t hold as short-holding-period returns of long-maturity bonds are often higher due to liquidity premiums and hedging concerns.

Liquidity Preference Theory: Adds liquidity risk premium to the pure expectation proposition, to compensate for loss of spending
power; it is positively related to maturity and may be larger during greater economic uncertainty when risk aversion is higher.

Warrants that forward rates are biased estimates of the market’s expectation of future rates because they include this liquidity
premium, as a positive-sloping yield curve may either indicate market expects future interest rates to rise; or rates are expected to
remain constant (or even fall), but the addition of the liquidity premium results in a positive slope.

Preferred Habitat: Agrees with LPT but disagrees that the premium is directly related to maturity; instead, supply and demand for
imbalances for funds in a given maturity range will induce lenders and borrowers to shift from their preferred habitats (maturity
range) to one that has the opposite imbalance.

To entice them to shift, they must be incentivized (lower/higher yields for borrowers/lenders) to compensate for the exposure to
price and/or reinvestment rate risk in the less-than-preferred habitat. Borrowers require cost savings (i.e., lower yields) and lenders
require a yield premium (i.e., higher yields) to move out of their preferred habitats. Hence, premiums are related to supply and
demand for funds at various maturities. Unlike the LPT a 10-year bond might have a higher or lower risk premium than the 25-year
bond depending on supply and demand factors!

Segmented Markets Theory: Yields are NOT determined by liquidity premiums and expected spot rates, rather by the
preferences of borrowers and lenders (operating in different ‘locked’ segments e.g. short-term, medium, term, long-term), which
drives the balance between supply of and demand for loans of different maturities.

For example, pension plans and insurance companies primarily purchase long-maturity bonds for asset-liability matching reasons
and are unlikely to participate in the market for short-term funds.