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Two theories explaining the term structure of interest rates: Segmented Markets Theory and Liquidity Premium Theory. The Segmented Markets Theory assumes no substitutability between bonds with different maturities and no effects of one market on another, leading to relatively larger demands for short-term bonds and lower yields for shorter maturities. In contrast, the Liquidity Premium Theory assumes imperfect substitutability and a preference for shorter maturities, but with investors requiring long-term bonds to have extra yields due to their lower liquidity. Both theories have implications for yield curves.
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B1. No Substitutability
Assumptions of
the Segmented Markets Theory
B.2 Preference for Shorter Maturity
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this year next year 1-year bond
2-year bond
1-year bond
Investors regard the two strategies as completely different, and never try to substitute one for another under any situation. Moreover, investors usually prefer to take the latter strategy, composed of short-term bonds.
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Yield from roll-over (^) < Yield from buy-and-hold
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Yield from roll-over (^) < Yield from buy-and-hold
Everyone substitutes 2-year bonds for 1-year bonds.
Price of 2-year bond Price of 1-year bond Interest rate on 2-year bond
Interest rate on 1-year bond
The process stops BEFORE two yields are equal because two bonds are not perfect substitutes.
( )( ) ( )
2 1 + 0. 02 1 + 0. 02 < 1 + 0. 03
( )( ) ( )
2 1 + 0. 01 1 + 0. 02 <<< 1 + 0. 04
( )( ) ( )
2 1 + 0. 015 1 + 0. 02 << 1 + 0. 035
( )( ) ( )
2 1 + 0. 3 1 + 0. 2 = 1 + 0. 25
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e
interest rate on a one-year bond i year ahead that we expect “today”
nt nt
e t n
e t
e t t
, ,
1 , 1 , 1 1 , 2 1 , 1
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3
1 2 3 4 5
2
1 2 3 4 5
When the expectations theory predicts a flat yield curve, LP theory predicts an upward- sloping one.
Even when the expectations theory predicts a downward- sloping yield curve, LP theory can still predict an upward- sloping one.
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the theory’s prediction is basically equal to the expectations theory’s, except for the positive bias for the slopes of yield curves.
the theory predicts an upward-sloping yield curve, except when short-term yields are expected to decline very sharply in the future.
