Theories for the shape of yield curve

Expectations hypothesis:
· Term structure of interest rates results from the market’s expectations of future interest rates. If the market expects inflation and consequently interest rates to be higher in future periods, it will expect higher forward rates leading to an upward sloping yield curve.

Problem: fail to account for why term structure of interest rates is upward sloping more often than downward sloping.

Liquidity preference theory:
· Investors demand a premium for investing in long-term bonds to compensate for higher risk. Borrowers are willing to pay the extra yield since short-term debt that needs to be rolled over exposes them to refinancing risk.

Problem: upward basis

Market segmentation theory:
· Various borrowers and lenders have preferred maturity ranges based on their objectives. These preferences are fixed. Thus the market is divided into distinct maturity segments, in which interest rates are determined by the demand and supply of loanable funds. If there is a shortage of loanable funds in the short term and excess in the long term, then short-term rates will be high and long-term rates will be low.