Theories of Term Structure
Pure Expectations Theory
Liquidity Premium Theory
Segmented Markets Theory
Preferred Habitat Theory

The Yield Curve
Yield curve shapes
Ascending
Descending
Flat
Humped

1.  Pure Expectations Theory
Long-term yields are always equal to the expected yield from any continuously rolled-over short-term bonds
The yield on a 30 yr bond should equal the expected yield on 120 successive rolled-over 3 mo bills, or any combination of short-term instruments
1.  Pure Expectations Theory
PE is reasonable because …
arbitrage should equalize yields.
If one instrument or maturity had a higher yield, everyone would desire it,
bidding up the price …
which lowers the yield!
1.  Pure Expectations Theory
PE does not predict any particular shape for the yield curve.

2.  Liquidity Premium Theory
People prefer more liquid assets.
Short-term bonds are more liquid than long-term bonds.
People are willing to pay more for short-term bonds.
The higher the price the lower the yield.
2.  Liquidity Premium Theory
Longer-term bonds yield more than shorter-term bonds …
given expectations.
Curve can have any shape,
but must be steeper than predicted by PE.

3.  Segmented Markets Theory
Long- and short-term securities are poor substitutes.
You would not want to finance a house with 120 continuously rolled-over 3 month commercial loans.
You would not want to finance temporary cash-flow borrowing with a 30 year mortgage.
3.  Segmented Markets Theory
Thus – segmented markets
Separate loanable funds markets for long and short-term securities.
Not clear how segregated the markets are.
6 mo bills better sub for 3 mo bills than 10 yr bonds.
3.  Segmented Markets Theory
Treasury can manipulate the yield curve if SM is correct.

4.  Preferred Habitat Theory
Borrowers and lenders have strong preferences for particular maturities.
Will deviate from preferred habitat if interest rates for other maturities are attractive enough.
Yield curve facts
YC is usually upward-sloping.
YC typically shifts up or down rather than rotating.
Short-term interest rates are more strongly procyclical than long-term rates.