term structure with this shape.” There are various theories that can account for any slope that the yield curve might take. First, there is the pure expectations theory where the forward rates exclusively represent the expected future rates. Since these rates can either increase or decrease for any time period, the yield curve can be sloped upward or downward for that time period. Second, there is the liquidity preference theory which asserts that investors do not like uncertainty and so much be offered a higher rate of return for longer term maturities. Thus, the forward rate will not only reflect expectations about future interest rates but also a premium that will be “liquidity” higher for longer term securities. Ceteris paribus, an increasing liquidity premium implies that the yield curve will be upward sloping. The preferred habitat theory also adopts the view that the term structure reflects the expectation of the future path of interest rates as well as a risk premium. However, the preferred habitat theory rejects the assertion that the risk premium must rise uniformly with maturity. The preferred habitat theory asserts that to the extent that the demand and supply of funds in a given maturity range do not match, some lenders and borrowers will be induced to shift to maturities showing the opposite imbalances. However, they will need to be compensated by an appropriate risk premium whose magnitude will reflect the extent of aversion to either price or reinvestment risk. Thus this theory proposes that the shape of the yield curve is determined by both expectations of future interest rates and a risk premium, positive or negative, to induce market participants to shift out of their preferred habitat. Thus, according to this theory, yield curves sloping up, down, flat, or humped are all possible. The market segmentation theory also recognizes that investors have preferred habitats dictated by the nature of their liabilities. This theory also proposes that the major reason for the shape of the yield curve lies in asset-liability management constraints (either regulatory or self-imposed) and/or creditors (borrowers) restricting their lending (financing) to specific maturity sectors. However, the market segmentation theory differs from the preferred habitat theory in that it assumes that neither investors nor borrowers are willing to shift from one maturity sector to another to take advantage of opportunities arising from differences between expectations and forward rates. Thus for the segmentation theory, the shape of the yield curve is determined by supply of and demand for securities within each maturity sector.
term structure with this shape.” There are various theories that can account for any slope that the yield curve might take. First, there is the pure expectations theory where the forward rates exclusively represent the expected future rates. Since these rates can either increase or decrease for any time period, the yield curve can be sloped upward or downward for that time period. Second, there is the liquidity preference theory which asserts that investors do not like uncertainty and so much be offered a higher rate of return for longer term maturities. Thus, the forward rate will not only reflect expectations about future interest rates but also a “liquidity” premium that will be higher for longer term securities. Ceteris paribus, an increasing liquidity premium implies that the yield curve will be upward sloping. The preferred habitat theory also adopts the view that the term structure reflects the expectation of the future path of interest rates as well as a risk premium. However, the preferred habitat theory rejects the assertion that the risk premium must rise uniformly with maturity. The preferred habitat theory asserts that to the extent that the demand and supply of funds in a given maturity range do not match, some lenders and borrowers will be induced to shift to maturities showing the opposite imbalances. However, they will need to be compensated by an appropriate risk premium whose magnitude will reflect the extent of aversion to either price or reinvestment risk. Thus this theory proposes that the shape of the yield curve is determined by both expectations of future interest rates and a risk premium, positive or negative, to induce market participants to shift out of their preferred habitat. Thus, according to this theory, yield curves sloping up, down, flat, or humped are all possible. The market segmentation theory also recognizes that investors have preferred habitats dictated by the nature of their liabilities. This theory also proposes that the major reason for the shape of the yield curve lies in asset-liability management constraints (either regulatory or self-imposed) and/or creditors (borrowers) restricting their lending (financing) to specific maturity sectors. However, the market segmentation theory differs from the preferred habitat theory in that it assumes that neither investors nor borrowers are willing to shift from one maturity sector to another to take advantage of opportunities arising from differences between expectations and forward rates. Thus for the segmentation theory, the shape of the yield curve is determined by supply of and demand for securities within each maturity sector.
Bond-Valuation-Tutorial-with-answer-key.docx