Expectation Theory: The Term Structure Of Interest Rate

Mishkin (2009) states that the term structure of interest rate explains that bonds with the same risk and liquidity have different interest rates because the bonds time to maturity are different from each other. He also states that the yield curve illustrates how the returns of bonds and maturity changes over time. There are four approaches that elaborates on the different shapes of the yield curve, they are the expectation, liquidity-premium, segment market and preferred habitat theory. These theories explain the different shapes the yield curve can take: upward, downward, inverted and humped yield, of which for example the upward slop yield states that there are higher returns when maturity increases.
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Hicks specified to say that “the rate of interest on perfectly safe securities is determined by nothing else but uncertainty of future interest rates seems to leave interest hanging by its own boot-straps”. Meaning that liquidity preference can account for the term structure of interest rates. THE SEGMENTED MARKETS THEORY
Culbertson (1957) explains that the Segmented Markets theory assume that financial instruments are not substitutable. It argues that investors are risk adverse and that this theory is used mostly by investment specialist and least by economist. Long term investors when trading in a segment of the yield curve are able to maximize their personal risk; therefore financial instruments are not substitutable across the term structure.

Investors tend to prefer bonds of one maturity because they are more concerned with a return on that specific maturity that they prefer, that’s why Mishkin (2009) explains why bonds with different maturities are not substitutes. The segmented markets theory cannot explain why interest rates with different maturities move together, however it does explain why yields usually tend to slope upwardly, but not in the case when short term interest are low and when the yield curve is downwardly sloped because short term interest rates are
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He argues that the markets can be segmented because of transactional cost. When transaction cost are high and above profits to be gained arbitrage will not occur, through the arbitrage process. Seo explains that the effectiveness of the arbitrage process are reduce due to transaction cost and will eventually affect the market segments. Seo (2003) believes that even though many other authors have rejected this approach, he continues to maintain that this factor should be included in future predicted movements of the yield curve. This theory has its weakness in that it cannot explain the three facts of the yield curve: the reason that long rates tend to remain stable relative to short rates, a persistent upward slope and the trend for long term rates and short term rates to move

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