Term Structure of Interest Rates: Meaning, Factors and Theories

In this article we will discuss about: Meaning of the Term Structure of Interest Rates 2. Factors Determining the Term Structure of Interest Rates 3. Theories.

Meaning of the Term Structure of Interest Rates:

The term structure of interest rates refers to the relationship between market rates of interest on short- term and long-term securities. It is the interest rate difference on fixed income securities due to differences in time of maturity. It is, therefore, also known as time-structure or maturity-structure of interest rates which explains the relationship between yields and maturities of the same type of security.

If two securities are identical in every respect except maturity, it is likely that they will sell in the market at different prices (or yields or interest rates). Generally, their prices will change in the same direction. If the short-term securities rise in price, the long-term securities will also rise in price.

People generally hold both short-term securities and they adjust their holdings of securities depending on the relative yields. Usually the long term securities tend to fluctuate more in price than the short-term securities, even though their yields do not fluctuate as much.

The relationship between yields and terms to maturity is depicted graphically by a yield curve. Figure 1 shows three yield curves. When short-term interest rates are above long-term interest rates, the yield curve slopes downward, as the curve FF. When short-term interest rates are below long-term interest rates, the yield curve slopes upward, as the curve RR. When the short-term yields equal long-term yields, the yield curve is flat, as the curve HL.

Factors Determining the Term Structure of Interest Rates:

What determines the shape of the yield curve? There are three factors which determine the term structure of interest rates. They are risk preference, supply and demand of securities, and expectations and uncertainty. These factors determine whether short-term interest rates are above or below long-term interest rates.

We discuss these factors as under:

1. Risk Preference:

Long-term security prices are sensitive to changes in interest rates because the chances to default are higher on long-term securities as compared to short-term securities. Therefore, lenders prefer to lend for short-term, if short-term and long-term securities have identical yields.

This would push up short-term prices of securities and bring down their yields. Hence the yield curve slopes upward. On the other hand, borrowers prefer to borrow for long period because they will not have to worry about rising interest rates or to renew their loans frequently.

They are, therefore, willing to pay more for long-term securities as compared to short-term securities. This will also cause the yield curve to slope upward. Thus the preferences of both lenders and borrowers lead to low rates on short-term securities and high rates on long-term securities, thereby bringing about an upward sloping yield curve.

2. Supply-Demand Conditions:

When the supply of short-term securities falls and that of long-term securities rises, the short-term interest rate comes down and the long-term interest rate is pushed up. The yield curve is upward sloping and vice versa.

If the demand for securities is more in the short-run market and the supply is more in the long-run market, this will lead to high short-term and low long-term interest rates, and the yield curve will be downward sloping. The opposite supply-demand conditions will lead to an upward sloping yield curve.

3. Expectations and Uncertainty:

Other factors affecting the yield curve are expectations and uncertainty. The expectation of the rise in the long-term interest rate explains that the short-term interest rate remains much below the long-term interest rate for any length of time. This produces an upward sloping yield curve.

Further, certain risks and uncertainties may lead to the same results. For instance, if people expect war, social disturbances, political upheavals, uncertainties, inflationary pressures, etc., they will not purchase long-term securities except at a low price or low current yield.

Theories of Term Structure of Interest Rates:

Many theories have been put forth by economists to explain differences in the structure of interest rates on short-term and long-term securities.

They are discussed as under:

1. The Expectations Theory:

The expectations theory regards future interest rates as the principal determinant of the present structure of interest rates. The theory originated with Irving Fisher, was perfected by Hicks in his Value and Capital, and is closely identified with Lutz.

Its Assumptions:

The expectations theory is based on the following assumptions:

1. All investors have definite expectations with respect to future short-term interest rates, and these expectations are held with complete confidence.

2. The objective of investors is to maximise expected profits, and they are prepared to transfer funds freely from one maturity to another in order to achieve this objective.

3. There are no costs associated with investment and disinvestment in securities. It means that there are no transaction costs.

4. The short-term and long-term interest rates are adjusted for any differences due to risk and liquidity.

5. ‘Safe’ securities of various maturities are perfect substitutes in the portfolios of investors.

6. Investors are profit maximisers who hold such financial assets in their portfolios which maximize return over a period they are held.

7. All investors hold with certainty the same expectations of how future rates are going to behave.

Explanation:

Given these assumptions, the theory states that the long-term interest rate at any point in time represents an average of expected short-time interest rates. Suppose a long-term security maturing after three years sells at the short-term interest rate of 2 per cent in the first year, and that the expected short-term interest rates in the second and third years are 3 per cent and 4 per cent respectively.

The long-term interest rate on this security will be the average of the short-term interest rates over the three years, that is 3 per cent (=2 per cent + 3 per cent+4 per cent=9 per cent/3). If the interest rate on the short-term security for the first year is expected to decline by 1 per cent the long-term yield on the three-year security will be 2.67 per cent (=1 per cent+3 per cent+4 per cent=8 per cent/3). On the other hand, if the interest rate is expected to increase by 1 per cent on the three-year security, then the long-term yield will be 3.33 per cent (=2 per cent+3 per cent+5 per cent=10 per cent/3).

The expectations theory holds that differences in yields on securities of different maturities are due to the fact that the market expects the interest rates on different securities to be the same over an equal period of time.

If this is not the case, the investor will buy security of one maturity by selling security of another maturity that he expects to provide him the highest yield. It is this “arbitrage procedure” (buying security of one maturity and selling of another maturity) which brings the equality of expected yields of different maturities.

According to Warren L. Smith, “Investors generally have repressive interest rate expectations. That is to say, at any particular time they have an opinion regarding the level of interest rates they regard as normal, and as short-term rates rise above or fall below this level, they expect them to regress back towards this normal level. Thus, as rates rise above normal, investors expect them to fall; and as rates fall below normal, investors expect them to rise.”

This relationship implies that:

(a) When short- term rates are expected to fall, current short-term rates will be above long-term rates and the yield curve will be negatively sloped, and

(b) When rates are expected to rise, current short-term rates will be below long-term rates and the yield curve will be positively sloped. By the same reasoning, when the short-term rate is at approximately the level judged to be normal and is expected neither to rise nor to fall, rates for all maturities will approximate a horizontal line.

These relationships between short-term and long-term interest rates are illustrated in Figure 1 where time to maturity, short or long-term, is taken on the horizontal axis, and yield or interest rate is taken on the vertical axis.

In the first case, when the current short-term rates are above the long-term rates and are expected to fall, the yield curve FF is negatively sloped. In the second case, when the current short- term rates are below the long-term rates, and are expected to rise, the yield curve RR is positively sloped. In the third case, when the current short-term rates equal the long-term rates and the short-term rates are expected neither to rise nor to fall, the yield curve HL is a horizontal line.

Prof. Lutz calls these yield curves as expectations curves which represent “the line up of the’ subjective’ long rates which correspond to people’s expectations after the latter have changed.” The key to the expectations theory is that both short and long-term securities are perfect substitutes for each other in the portfolios of investors.

If the supply of long-term securities goes up and that of short-term securities goes down, it makes no difference as far as yields are concerned. Long- term securities will be exchanged for short-term securities with no change in yields as long as expected future short-term rates are unchanged.

Its Policy Implications:

The policy implications of this theory are that if the government wishes to replace a given amount of long-term debt with an equivalent amount of short-term debt, such a policy will have no impact on the Structure of interest rates. This is because both long-term and short-term debts are regarded as perfect substitutes in the portfolio of investors.

This is shown in Figure 2 (A) and (B). Panel (A) depicts the demand and supply of short-term debt and Panel (B) that of long-term debt. Each type of debt is measured on the horizontal axis and yield on the vertical axis.

The demand curves D_s and D_L are drawn with infinite elasticity because both debts are perfect substitutes. The supply curves S_s and S_L are drawn perfectly inelastic because the quantities of short-run and long-term debts are fixed. Assume that the long-term interest rate (yield) lies above the short-term interest rate, i.e.., OR_L > OR_s.

This is because the future short-run interest rate is expected to be higher than the current short-run rate. If the government wishes to redeem (retire) S_L– S_L1 of long-term debt and replaces it with S_s-S_s1 of short-term debt, this is possible without any change in the relative yields of the two kinds of debt. These remain the same at OR_L and OR_s respectively.

Again, as all types of short-term and long-term bonds (securities) are perfect substitutes, therefore the central bank cannot influence the term structure of interest rates as long as it does not affect the expectations of borrowers and lenders.

Its Criticisms:

However, the expectations theory has been criticised on several points:

1. Lenders may have expectations about long-term interest rates that may be independent of their expectations about short-term interest rates.

2. The theory presupposes that investors can make long-term expectations about short-term interest rates. But it is doubtful if such predictions can be made accurately.

3. Critics doubt the efficacy of changes in the central bank discount rates to influence the long-term interest rates. For instance, a reduction in the discount rate can bring a fall in the long-term rates only if the expectation is generated that short-term interest rate will remain low. This will prevent the discount rate being changed very often by the central bank.

4. If open market operations which influence the slope of the yield curve are not successful, the expectations theory fails. Suppose the central bank tries to keep long-term rates higher than short-term rates by supplying short-term market with large funds.

In this situation, investors expecting that they will gain over the long period would shift from short-term to long-term securities. This would tend to equalize the short-term and long-term rates and the yield curve would be horizontal like HL, rather than like RR in Figure 1.

5. The assumption of the theory that investors hold with certainty expectations of future short-run interest rates is not correct. This is because expectations of people for short-run interest rates are occasionally certain.

6. This assumption is also away from reality that the expectations of borrowers and lenders are similar. In fact, the expectations of borrowers and lenders regarding short-term and long-term rates are quite different from each other.

7. The theory fails to explain how expectations relating to future short-term interest rates are formed.

8. It is also wrong to assume that transaction costs are zero. In reality, borrowers and lenders are required to incur transaction costs every time when they buy and sell securities.

2. The Segmented Markets Theory:

The segmented markets theory is known by various names such as institutional, hedging or segmentation. According to this theory, investors are much averse to risk. So they hedge against risks by matching the maturity of their assets with that of their liabilities.

If the maturity of an investor’s assets is longer than that of his liabilities, he incurs a capital loss when he is forced to sell his assets before they are due for redemption. On the other hand, if the maturity of an investor’s assets is shorter than that of his liabilities, he runs the risk of income loss. In order to avoid the two kinds of risks, investors match the maturities of their assets and liabilities.

Its Assumptions:

This theory is based on the following assumptions:

1. Assets of different maturities are imperfect substitutes with each other.

2. Markets for assets of different maturities are divided into separate markets.

3. Interest rates for one type of asset in every market are determined by their demand and supply which, in turn, affect the yield to maturity.

4. There is uncertainty about the behaviour of interest rates in future.

The Theory:

The segmented markets theory holds that short-term and long-term interest rates are determined in several separated or segmented markets. Some investors prefer short-term securities, while other investors, such as insurance companies, prefer long-term securities. Thus securities of different maturities are imperfect substitutes for buyers and sellers of securities in the market.

Consequently, the yield curve is the result of several demand and supply curves for securities of different maturities. Given the demand for securities, if the supply of short-term securities is less than the demand for long-term securities, the short-term interest rate will be higher than the long-term interest rate. In this situation, the yield curve will slope downward to the right, as shown by the curve Y in Fig. 3 (C).

In Panel (A) of the figure, D_s and S_s are the demand and supply curves of short-term debts respectively which are in equilibrium at point E_s. Thus they determine 6% equilibrium interest rate on short-term securities. In Panel (B), D_L and D_s are the demand and supply curves respectively of long-term debts which determine 5% equilibrium interest rate at point E₁ on long-term securities. These interest rates provide the downward sloping yield curve Y in Panel (C).

On the contrary, given the demand for securities, when the supply of short-term securities is greater than the demand for them, the short-term interest rates will be lower than the long-term interest rates. In such a situation, the yield curve will slope upward to the right, as shown in Fig. 4 (C).

In Panel (A) of the figure, D_s and S_s curves determine 4% short-term equilibrium interest rate at point E_s on short-term assets. Similarly in Panel (B), D, and S_L curves determine 5% long-term equilibrium interest rate at point E_r .These interest rates provide the upward sloping yield curve Y in Panel (C). Thus, according to the segmented market theory, the market rates on securities of different maturities are determined by separate conditions of demand and supply in each maturity. Across the maturity spectrum, there are a number of separate markets.

Its Policy Implications:

The policy implications of this theory are that if the government wishes to replace a given amount of long- term debt by a short-term debt, it will be successful in twisting the structure of interest rates. In this theory, D_s and D_l are the demand curves for long-term and short- term debts respectively which are less than perfectly elastic with respect to yield rates, as shown in Figure 5 (A) and (B).

This is because the two types of debt are not perfectly substitutable. Suppose that the government wants to retire B-B_L1 of long-term debt and replace it with B_s1-B_s short- term debt. Notice that the spread between the rates has been reduced. When the government substitutes long-term debt by short-term debt, the supply of long-term debt is reduced from S_L to S_L1 and the long-term interest rate rises from R_L to R_L1, as shown in Panel (B) of the figure.

On the other hand, the supply of short-term debt increases from S_s to S_s1 which brings a fall in the short-term interest rate from R_s to R_s1 as shown in Panel (A) of the figure. Notice that the fall in the short-term interest rate is less than the rise in the long-term interest rate: R_S-R_S1 < R_L-R_L1.

Another implication of this theory is that the central bank can affect the yields to maturity of securities or the term structure of interest rates by permitting the relative supplies of long-term and short-term securities. Again, the central bank cannot affect the long-term interest rate by changing only the supply of short- term securities.

Its Criticisms:

The segmented market theory has been criticised on the following grounds:

1. This theory explains that changes in preferences for securities of different maturities will alter in the form of the yield curve. But it does not explain changes in the structure of yields.

2. This theory is based on the assumption that short-term and long-term interest rates are not related to each other. But empirical evidence does not support it. It shows that short-term and long-term interest rates move together. When short-term interest rates fall or rise, the long-term interest rates move in the same direction.

Conclusion:

Despite these criticisms, the segmented markets theory is supported by institutional practices.

Accordingly, commercial banks which place emphasis on liquidity, deal in short-term securities, and insurance companies with long-term securities. Similarly, inventories are financed with short-term loans, and purchases of houses with long-term mortgages.

Its Superiority Over Expectations Theory:

The segmented market theory is superior to the expectations theory on the following counts:

1. The segmented market theory is superior to the expectations theory because it does not assume the unrealistic assumption of the expectations theory that short-term and long-term securities are perfect substitutes. The risks in short-term securities are less than those in long-term securities.

If a person sells his security before its maturity and the interest rate is more than expected, the price of the long-term security will be less as compared with the short-term security. Thus, short-term and long-term securities are not perfect substitutes.

2. The segmented market theory is also superior to the expectations theory because it rejects the assumption of the latter that the future interest rates are known with certainty. In reality, they are uncertain. Due to large price-changes of long-term securities, there is much uncertainty in holding them. On the other hand, there is great uncertainty of future yields in holding short-term securities.

3. Another reason of the superiority of segmented market theory over the expectations theory is that it does not explain the term structure of interest rates on the basis of the average of expected short-term interest rates. Rather, the segmented market theory determines both the short-term and long-term interest rates in the form of demand and supply of a particular security, as happens in reality in a financial market.

4. As against the expectations theory, the segmented market theory does not explain a unique relation between short-term and long-term interest rates. In reality, the behaviour of short-term and long-term interest rates depends on the relation between money market and bond market. Short-term and long-term interest rates in both markets are determined by the demand and supply of each type of security.

5. The segmented market theory is also superior to the expectations theory because it is supported by institutional practices. Accordingly, commercial banks which place emphasis on liquidity deal in short-term securities, and insurance companies with long-term securities. Similarly, inventories are financed with short- term debts and purchases of houses with long-term mortgages.

3. The Substitutability Theory:

The substitutability theory holds that short-term and long-term securities are substitutes for borrowers and lenders. When buyers and sellers of securities are engaged in arbitrage and switching operations, they tend to eliminate discrepancies between long-term and short-term interest rates in the short run.

For such operations, the theory assumes optimising behaviour on the part of buyers and sellers, and relatively free and unrestricted markets.

Given these assumptions, prices of short-term securities move in the same direction as the long-term securities. For instance, a fall in the price of short-term securities (or a rise in the short-term interest rates) will be followed by a fall in the prices of long-term securities (or a rise in the long-term interest rates), and vice versa.

The forces which lead to such parallel moments between short-term and long-term interest rates are (a) the substitutability of alternative investment opportunities on the part of lenders and the alternative means of financing on the part of borrowers, and (b) by tendency for changes in credit and monetary conditions to have a simultaneous impact on the financial market.

The substitutability theory is important for conducting monetary policy when by arbitrage and switching operations, changes are transmitted from one sector of the financial market to the other by the central bank.

However, it is doubtful if investors will readily switch over from short-term to long-term securities. Therefore, the perfect substitutability assumed between the two types of securities breaks down.

4. The Keynesian Theory:

There are two theories associated with Keynes. The first is known as the fluidity theory which Keynes put forth in his Treatise on Money, and the second is called the psychological theory which he propounded in his General Theory.

The fluidity theory holds that there is correspondence, both in direction and timing, of movement in interest rates with short-term interest rates moving proportionately more than long-term interest rates. Further, any action on the part of the central bank to influence short-term interest rates is readily transmitted to long- term interest rates.

But Keynes himself admitted that during a slump in security prices, the central bank’s action to influence short-term securities through open market operation may not help in reducing yield on long-term securities.

The psychological theory holds that the long-term interest rate is a highly psychological phenomenon dominated by short-run expectations about its future level. The long-term interest rates are sticky in the downward direction even when short-term interest rates decline substantially.

This is due to the psychology of investors. If they believe that the long-term interest rates have reached the “irreducible conventional minimum” and the next change would be in the upward direction, they will not deal in long-term securities for fear of capital loss. This happens during a depression when liquidity preference is perfectly interest elastic.

All efforts on the part of the central bank to purchase short-term securities in the open market will fail to persuade investors to buy long-term securities.

These Keynesian theories of term-structure of interest rates have been neglected and attention has focused on the expectational theory and the segmented markets theory which have been empirically tested.

5. The Liquidity or Risk Premium Theory:

A variant of the Expectations Theory and the Keynesian Fluidity Theory is called the Liquidity or Risk Premium Theory. The theory rejects the view that short-term and long-term securities are comparable except for maturity. But it accepts the view that yields on various maturities are related to each other by the expectations of long-run and short-run rates.

Thus it adds to the expectations theory that lenders and borrowers differ in their attitudes to short-term and long-term securities.

Lenders prefer to lend for short-term and borrowers prefer to borrow for long-term. This is because the return on short-term securities is certain but that on long- term securities is uncertain on account of uncertainties of future interest rates.

The uncertainty is greater, the longer the maturity of securities. Thus risks associated with long-term securities are greater. Under the circumstances, lenders prefer the safer short-term securities. To induce the market to hold the long-term securities supplied by long-term borrowers, the expected return on them must exceed that on short-term securities by a premium which is called an expected risk or liquidity premium. Thus long-term securities being more risky would command larger liquidity premiums.

As long-term securities carry higher risk premium, it follows that interest rates increase as one moves from short-term to long-term securities.

The higher interest rates on longer-term securities are determined by two components:

(a) the expectations component, and

(b) the liquid premium component.

The liquidity premium component will always lead to higher interest rates on long-term securities than on short-term securities. This tendency has been called by Hicks the “constitutional weakness” or the “congenital market weakness” by some other supporters of the theory. This tendency of higher interest rates may be counteracted partially or even fully by the expectations component which is assumed as given.

Prof. Newelyn in his Theory of Money has modified this theory by dropping the expectations component and introducing the concepts of encashment and requirement periods. The concept of encashment period is associated with the lender. The lender calculates the period for which he is prepared to lend his funds and at the end of which he will en-cash them.

This is the encashment period. If he lends his funds for a period shorter than the encashment period, he is not certain about his interest income which he may be able to get for the remaining period. A part of the interest income will depend on the future behaviour of interest rates.

Thus the lender runs an “income risk”, according to Newelyn, which the lender can avoid if the duration of the loan is equal to the encashment period. On the other hand, if the loan is longer than the encashment period, he runs a capital risk.

This may be due to differences in the market price of a loan from its face value. It follows that the lender can avoid both the risks if he lends his funds exactly for the encashment period. So long as the duration of the loan does not exceed the encashment period, the lender is not to be paid any liquidity premium to induce him to part with his funds.

The concept of the requirement period is related to the borrower who calculates the period for which he requires the loan and at the end of which he will repay it. If the borrower borrows for a period equal to his requirement period, the interest cost of the loan is predetermined and there is no uncertainty about this. When the borrower borrows for the duration of the requirement period, he avoids the income risk which is the interest risk cost.

If he borrows for a shorter period than the requirement period and thinks of borrowing for the remaining period later on, he runs the risk of incurring a different interest cost, and thereby incurs an income risk. If he borrows for a longer period than the requirement period, he may pay a price different from the face value of the debt for the excess period. In this case, he runs the capital risk. The borrower can avoid both the risks if he borrows exactly equal to the requirement period.

We find that both the lender and the borrower can avoid the income and capital risks if the maturity of the loan coincides with the encashment and the requirement period receptively. Newelyn’s analysis is based on the presumption that the average requirement period of the borrowers exceeds the average encashment period of the lenders.

This lures the lenders to lend for a period longer than the encashment period and thereby run the capital risk. As a result, longer maturity loans would be carrying a premium against the capital risk. The premium would be larger as we move from shorter to longer maturities which would move the interest rates upward. Thus long-term interest rates tend to be higher than short-term interest rates and the market demands a premium called liquidity premium to hold long-term securities.

According to Newelyn, “This can be done by relating the maturity of existing assets to the maturity which would be required if all assets were to mature at the date at which the holders anticipate that encashment be required.”

This is explained in Figure 6. The encashment curve E shows the cumulative total funds measured on the horizontal axis increasing to F as the period within which encashment is expected to increase to time T. Similarly, the maturity curve M shows the cumulative total assets increasing to F as the period within which their maturity increases to time T.

The curve M rises from a positive value of M at zero life to maturity, indicating the existence of money and quasi-money (M). Both the curves represent the same total amount of funds (F), reflecting that the total funds must be distributed among the existing stock of assets. But they explain the different distributions of two characteristics of this total of funds:

(i) The encashment period of the funds and the length of life to maturity of the assets in which the funds must be held; and

(ii) The time period T is assumed to be sufficiently long to include all bonds and the maximum encashment period.

The area under the maturity curve M will change inversely with changes in the degree of maturity of the existing stock of assets. On the other hand, the area under the encashment curve E will change inversely with changes in the degree of maturity consistent with zero capital risk for the investor.

Therefore, the general level of interest rates will be a function of the difference between the two areas because this difference measures the extent to which investors must be induced to accept the risk of capital loss if the demand for maturity is to be equated with the given supply of funds.

Conclusion:

This theory is more realistic than the expectations theory because it takes into consideration the risk involved by investors of securities of different maturities. Rather, it is an improvement over the other term structure theories and is the most acceptable among the majority of economists.

6. The Preferred Habitat Theory:

Modigliani and Sutch have propounded the Preferred Habitat Theory of the term structure of interest rates. It combines the main features of both the expectations and segmented market theories. According to this theory, investors have a preference for securities of a given term and they want to choose them according to their expected yield.

But they will be willing to purchase securities of some other term by substituting them for securities of a preferred term. They will do so if they are compensated by the term premium. The term premium is compensation or an additional yield which induces investors to purchase securities with a different term to maturity than their preferred term.

According to this theory, different investors have different habitats. Suppose an investor has n period habitat which means that he has funds which he does not need for n periods and keeps them invested in securities for n periods. He knows exactly the result of investment as measured by terminal value of his wealth.

If he invests for a short-period, his outcome is uncertain, as it will depend on the future course of the short-term rates. Moreover, he will have to incur greater transaction costs. Thus, if he has risk aversion, he will prefer to hold long-period securities. On the contrary, if the average short-term rates exceed the long-term rate by an amount sufficient to cover extra transaction costs and to compensate him of the extra risk of holding short- period securities, he will stay short. But risk aversion should not lead him to prefer to stay short.

If the investor invests in maturities longer than n period habitat, he would face uncertainty as to the price he can get for his un-matured securities. Thus risk aversion should lead him to hedge against risks by continuing to remain in the same maturity habitat unless other longer or shorter maturities offer an expected premium sufficient to compensate for the risk and cost of moving out of his habitat. Similar considerations apply to the borrowers in the market.

Under this theory, if the n period demand for funds exceeds the funds with n period habitat, there will arise a premium in the n period maturity and vice versa. Such premiums have a tendency to bring about shifts in funds between different maturity markets in two ways – first, through the speculation of investors who are tempted out of their natural habitat by the lure of higher expected returns, and second, through arbitrage by intermediaries by borrowing in the maturity range where the expected return is low, and by lending where the expected return is high.

Thus the preferred habitat theory tells that an investor chooses securities on the basis of both the expected yield on securities and his preference for securities with a particular maturity. He will purchase a security of undesirable term to maturity only if he receives a term premium.

Suppose an investor prefers a one-year security because he needs funds at the end of the year. If he purchases a two-year security and sells it at the end of one year before its maturity, he incurs a risk If the interest rate rises during this period, he will be forced to sell the security at a lower price (because security prices and interest rates are inversely related).

In addition, he will have to pay commission to the broker in order to sell the security before maturity of two years. Therefore, the investor must receive a term premium to purchase a long-term security when his preference is for a short-term security.

The preferred habitat theory explains the shapes of the yield curve in a better way than the expectations hypothesis and the segmented market hypothesis. It explains not only upward sloping yield curves but also horizontal and downward sloping yield curves. It also explains why the yield curves are usually upward sloping rather than downward sloping.

When the term premium is positive and there are expectations of short-term interest rates to rise by a large amount, the yield curve will be upward sloping, as shown in Fig. 7 (A). Again, when the term premium is positive and the short-term interest rates are expected to rise by a small amount, the yield curve will be relatively horizontal (flat), as shown in Panel (B).

If the term premium is positive and the short-term interest rates are expected to fall considerably, the yield curve will be downward sloping, as shown in Panel (C). If, however, the short-term interest rates are expected to remain constant or fall a little, the yield curve will slope upward on account of the term-premium on long-term securities.

Conclusion:

The preferred habitat theory points out that expectation, risk premium and market segmentation all play a part in determining the term structure of interest rates. If lenders and borrowers in the capital market are not rigidly tied to market segments, but simply have preferred habitats, then expectations play their part in determining interest rates which are not completely independent. Other things being equal, lender’s preference for liquidity will have a tendency for long-term rates to be above short-term rates.

In reality, the expectations and segmented market theories are the extreme versions of the preferred habitat theory. In the expectations theory there is no term premium, that is, it is zero. It is simply the average of expected rates during the term of the long-term security.

Investors do not require any premium to hold securities of different maturities. But in the segmented market theory, the term premium is infinite. There is no term interest rate which can be offered to an investor to induce him to purchase a security whose maturity does not match his preferences.

Empirical evidence on the habitat theory suggests that the link between expected short-term rates and long-term rates is quite strong, thus justifying the expectations theory. Further, the expected return from long- term securities tends to exceed the short rate by a positive premium.

The existence of such a positive premium would indicate a systematic tendency for the primary supply of funds to exceed the primary demand for them in the short period market, and to fall short of the primary demand in the long period market. Under these conditions, the size of the premium on long-term securities would depend on the facilities for effective arbitrage operations.