Liquidity Premium Theory
The second theory, the liquidity premium theory of the term structure of interest rates, is an extension of the unbiased expectations theory. It is based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security’s value, which increases with an asset’s maturity. Specifically more active secondary market) and have less price risk (due to smaller price fluctuations for a given change in interest rates) than long-term securities. As a result, investors prefer to hold shorter-term securities because they can be converted into cash with little risk of a capital loss (i.e., a fall in the price of the security below its original purchase price). Thus, investors must be offered a liquidity premium to buy longer-term securities which have a higher risk of capital losses.
The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected short-term rates (as under the unbiased expectations theory), plus liquidity risk premiums that increase with the maturity of the security. Figure 2–9illustrates the differences in the shape of the yield curve under the unbiased expectations hypothesis versus the liquidity premium hypothesis. For example, Panel (c) of Figure 2–9 shows that according to the liquidity premium theory, an upward-sloping yield curve may reflect investors’ expectations that future short-term rates will be flat, but because liquidity premiums increase with maturity, the yield curve will nevertheless be upward sloping. Indeed, an upward-sloping yield curve may reflect expectations that future interest rates will rise (Panel a), be flat (Panel c), or even fall (Panel b), as long as the liquidity premium
The second theory, the liquidity premium theory of the term structure of interest rates, is an extension of the unbiased expectations theory. It is based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security’s value, which increases with an asset’s maturity. Specifically more active secondary market) and have less price risk (due to smaller price fluctuations for a given change in interest rates) than long-term securities. As a result, investors prefer to hold shorter-term securities because they can be converted into cash with little risk of a capital loss (i.e., a fall in the price of the security below its original purchase price). Thus, investors must be offered a liquidity premium to buy longer-term securities which have a higher risk of capital losses.
The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected short-term rates (as under the unbiased expectations theory), plus liquidity risk premiums that increase with the maturity of the security. Figure 2–9illustrates the differences in the shape of the yield curve under the unbiased expectations hypothesis versus the liquidity premium hypothesis. For example, Panel (c) of Figure 2–9 shows that according to the liquidity premium theory, an upward-sloping yield curve may reflect investors’ expectations that future short-term rates will be flat, but because liquidity premiums increase with maturity, the yield curve will nevertheless be upward sloping. Indeed, an upward-sloping yield curve may reflect expectations that future interest rates will rise (Panel a), be flat (Panel c), or even fall (Panel b), as long as the liquidity premium
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| Figure 2–9 |
increases with maturity fast enough to produce an upward-sloping yield curve. The liquidity premium theory may be mathematically represented as:
Market Segmentation Theory
The market segmentation theory argues that individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium). Accordingly, the market segmentation theory does not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold For example, banks might prefer to hold relatively short-term U.S. Treasury bonds because of the short-term nature of their deposit liabilities, while insurance companies may prefer to hold long-term U.S. Treasury bonds because of the long-term nature of their life insurance contractual liabilities. Accordingly, interest rates are determined by distinct supply and demand conditions within a particular maturity segment (e.g., the short end and long end of the bond market).
The market segmentation
theory assumes that investors and borrowers are generally unwilling to shift from one maturity sector to another without adequate compensation in the form of an interest rate premium. Figure 2–10 demonstrates how changes in the supply curve for short- versus long-term bond segments of the market result in changes in the shape of the yield to maturity curve. Specifically in Figure 2–10 , the higher the yield on securities (the lower the price), the higher the demand for them. 5 Thus, as the supply of securities decreases in the short - term market
The market segmentation
theory assumes that investors and borrowers are generally unwilling to shift from one maturity sector to another without adequate compensation in the form of an interest rate premium. Figure 2–10 demonstrates how changes in the supply curve for short- versus long-term bond segments of the market result in changes in the shape of the yield to maturity curve. Specifically in Figure 2–10 , the higher the yield on securities (the lower the price), the higher the demand for them. 5 Thus, as the supply of securities decreases in the short - term market
and increases in the long - term market, the slope of the yield curve becomes steeper . If the supply of short -term securities had increased while the supply of long - term securities had decreased , the yield curve would have a flatter slope and might even have sloped downward. Indeed, the large-scale repurchases of long-term Treasury bonds (i.e., reductions in supply) by the U.S. Treasury in early 2000 has been viewed as the major cause of the inverted yield curve that appeared in February 2000.
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