What are the different theories explaining the term structure of interest rates?

The term structure of interest rates (yield curve) explains the relationship between interest rates and the time to maturity of debt securities. The following theories explain it:

1. Expectations Theory

   • Assumes investors are indifferent between short- and long-term bonds.
   • Long-term rates are the average of current and expected future short-term rates.
   • Predicts an upward-sloping curve if short-term rates are expected to rise.

2. Liquidity Preference Theory

   • Investors demand a liquidity premium for holding long-term bonds.
   • Explains why long-term rates are higher than short-term rates, even if expectations are stable.

3. Market Segmentation Theory

   • Different investors prefer different maturity periods (e.g., banks for short-term, pension funds for long-term).
   • Rates depend on supply and demand in each segment, not expectations.

4. Preferred Habitat Theory

   • A mix of expectations and segmentation: investors have a preferred maturity but can be induced to shift with a premium.

5. Arbitrage Theory (Pure Expectations Theory)

   • Assumes perfect markets and no risk premiums; long-term rates reflect expected future short-term rates.