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Theories of the Term Structure


  • Three theories are used to explain the shape of the term structure                
  • Expectations theory
  • The long rate is the geometric mean of expected future short interest rates
  • Liquidity preference theory
  • Investors must be paid a “liquidity premium” to hold less liquid, long-term debt  
  •  Where rpn is the risk premium associated with an n year bond
  • Market segmentation theory
  • Investors decide in advance whether they want to invest in short term or the long term
  • Distinct markets exist for securities of short term bonds and long term bonds
  • Supply demand conditions decide the prices

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