Yield Curve Theories

Pure Expectations Theory -
Liquidity Preference Theory -
Market Segmentation Hypothesis -



Pure Expectations Theory

Term structure reflects the markets current expectation of the future rates. A rising yield curve is explained by investors expecting short-term interest rates to go up.
This says that the only factor that affects the shape of a yield curve is the markets expectation about future interest rates.



Liquidity Preference Theory

Investors prefer liquidity, upward sloping yield curve. Intuitively long-term investments are more risky than short-term so long dated yields should be higher than short-term yields.



Market Segmentation Hypothesis

Shape is determined by the supply and demand of the securities within each maturity sector. Shape is best explained by a combination of all 3 theories.




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