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Theories of Term Structure

There are three theories that help to explain the term structure of interest rates, or the fundamental relationship between the yield-to-maturity and length-to-maturity of a sample population of comparable bonds. These theories shed light on the various shapes of yield curves and the factors that drive their behavior over time.

Liquidity Preference Theory

The Liquidity Preference Theory is based on the premise that investors would prefer to hold short-term securities rather than long-term securities to minimize their exposure to risk, all else constant. The theory suggests that bonds with longer-term maturities must offer higher yields to attract investors. The liquidity preference theory helps to explain why yield curves possess an upward slope during normal market conditions. In general, yield curves slope upward because investors demand greater returns for bonds with longer lengths-to-maturity.

Expectations Theory

The Expectations Theory suggests that the term structure of interest rates is based entirely on investors’ expectations about future short-term rates. Specifically, the theory holds that all intermediate-term and long-term rates are derived from projected short-term rates. If investors believe that future short-term rates will increase then the yield curve’s upward slope will become steeper as intermediate and long-term yields adjust upward. If investors believe that future short-term rates will decrease the yield curve’s upward slope will flatten as intermediate-term and long-term yields adjust downward. The expectations theory is widely accepted by market participants. The theory is the premise behind the application of spot rates and forward rates which will be introduced in proceeding tutorials.

Market Segmentation Theory

The Market Segmentation Theory is based on the fact that institutional investors and major market participants have preferences regarding the lengths-to-maturity of the securities they hold. For example, insurance companies generally prefer to invest in bonds with long-term maturities. Banks and other financial institutions often prefer intermediate-term and short-term securities. The Market Segmentation Theory states that the yield offered on securities of a particular length-to-maturity will be partially determined by the investing strategies of the institutional investors who participate in that market.

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