Theories of the Term Structure
Overview
There are essentially three theories that explain the shape of the term structure.
Rational Expectations
The rational expectations hypothesis asserts that fixed income investors do not prefer on maturity over another.
In fact, if an investor wishes to invest her money for 10 years, she could invest in a
zero coupon bond with a 10 year maturity, or she could invest in a 5 year bond, and then re-invest into
another 5 year bond at maturity. The rational expections hypothesis asserts that such an investor is
roughly indifferent between the two strategies because the market will adjust the term structure of interest
rates such that the expected return of either strategy should be equal. If they were not, the invesetors in the
market would begin to sell one maturity and buy the other until the expectations line up.
(Of course, if the investor were to invest in a 5 year bond, and enter into a forward contract for the second
five year term, the return would be exactly equal by arbitrage arguments.)
Market Segmentation
The market segmentation hypothesis states that there is little relationship between different spots on the term structure.
In fact, it asserts that the curve represents different market segments, and the rate (price) of one segment is determined
by the supply and demand for that segment alone, independent of the other segments.
Of course, it is often asserted that the curve, while segmented, should at least be continuous, in the sense
that two segments are independent of each other, except when they are infinitesimally close, in which case they
should be close.
Liquidity Preference
The liquidity preference theory is more or less an extension of the rational expectations hypothesis. It asserts that
investors are indifferent to spots on the curve, other than that shorter maturities have greater liquidity. That is,
shorter maturities return their cash earlier and are more desired by investors who have certain liquidity needs.
Therefore, the liquidity preference takes the curve as determined by rational expectations but then adds a premium
to the longer less liquid end of the curve.
