101 Concepts for the Level I Exam

Essential Concept 64: Traditional Term Structure Theories

Unbiased expectations (Pure expectations theory):

It states that the forward rate is an unbiased predictor of the future spot rate.
The implication is that bonds of any maturities are perfect substitutes for each other.
For example, buying a bond with a maturity of five years and holding it for three years has the same expected return as buying a three-year bond or buying a series of three one-year bonds.
The major limitation of this theory is that it simplistically assumes that investors are risk neutral.

Local expectations:

This theory is more rigorous than the unbiased expectations theory. Rather than assuming that the bonds of any maturity will give the same returns, it assumes that the expected return for every bond over the short run is the risk free rate.
The limitation of the theory is that it is often observed that short-holding-period returns on long-dated bonds do exceed those on short-dated bonds.

Liquidity preference theory:

Liquidity preference theory states that liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term and that these premiums increase with maturity.
Thus, the forward rate provides an estimate of the expected spot rate that is biased upward by the amount of the liquidity premium.
Existence of liquidity premiums implies that the yield curve will typically be upward sloping.
The limitation of this theory is that it fails to offer a complete explanation of the term structure.

Segmented markets theory:

This theory states that the yield of securities of a particular maturity is determined entirely by the supply and demand for funds of that particular maturity.
Each maturity sector is considered a segmented market, and the yield in each segment is independent of the yield in other segments.
The theory is consistent with a world where there are asset/liability management constraints, either regulatory or self-imposed.

Preferred habitat theory:

The preferred habitat theory is similar to the segmented markets theory in suggesting that many participants have strong preferences for particular maturities.
However, it does not state that yields at different maturities are determined independently of each other.
If the expected additional returns to be gained become large enough, institutions will be willing to deviate from their preferred maturities or habitats.