Question

With the following Interest Rate Theories, Expectation, Liquidity, Market Segmentation, & preferred habitat hypothesis theory how do each of these theories explain changes in the economy?

Answer 1

1. Market Segmentation Theory (MST) states that the yield curve is determined by supply and demand for debt instruments such as bonds. Generally, the debt market is divided into 3 major categories: short-term, intermediate-term, and long-term. The difference in the supply and demand causes the difference in bond prices, that difference will depend on current interest rates and expected future interest rates. If current interest rates are high, then future rates will be expected to decline, thus increasing the demand for long-term bonds by investor. On the other hand, if current interest rates are low, then bond buyers will tend to avoid long-term bonds so that they are not locked into low rates. Borrowers generally want to lock in low rates, so the supply for long-term bonds will increase. Hence, a lower demand and a higher supply will cause long-term bond prices to fall, thereby increasing their yield.

2. Liquidity premium theory of the term structure of interest rates explains the generally upward sloping yield curve for bonds of different maturities.

Liquidity Premium = Illiquid Bond YTM – Liquid Bond Yeild

Interest rate risk is the risk that bond prices will drop if interest rates rise, since there is an inverse relationship between bond prices and interest rates. Interest rate risk is only a real risk if the bondholder wants to sell before maturity, but it is also an opportunity cost, since the long-term bondholder forfeits the higher interest that could be earned if the bondholder's money was not tied up in the bond. Hence this effects the economy if the bonds are more liquid.

3. The expectations hypothesis states that different term bonds can be viewed as a series of 1-period bonds, with yields of each period bond equal to the expected short-term interest rate for that period.If future interest rates are expected to rise, then the yield curve slopes upward, with longer term bonds paying higher yields. However, if future interest rates are expected to decline, then this will cause long term bonds to have lower yields than short-term bonds.

4. Preferred Habitat Hypothesis is an extension of the market segmentation theory, in that it states that lenders and borrowers will seek different maturities other than their preferred maturities if the yield differential is favorable enough to them. For instance, if short-term rates are a lot lower than long-term rates, then bond issuers will issue more short-term bonds to take advantage of the lower rates even though they would prefer longer maturities and lenders will tend to buy long-term debt if the yield advantage is significant, even though carrying long-term debt has increased risks.