Compare and contrast the market segmentation theory liquidit

Compare and contrast the market segmentation theory, liquidity premium theory, and the unbiased expectations theory of the term structure of interest rates.

Solution

Market segmentation theory states the the securities of varied maturity will not have any relationship with each other. It means that it is doest not neccesserily true that long maturity securities will have high rates and vise versa. This theory believes that there are plenty of other parameters like age, risk profil etc. which play important role in determining security price. In short that it is based on the supply and demand of a particular security.

For example :If there are 2 bonds, both with different maturity say 10 years and 20 years. As per this theory, we cannot simply say that 10 year bond will have lower yield than 15 year because these two bonds will have different supply and demand profile.

Liquidity Premium theory, as it name suggests, is based on sole principle that securities with long maturities will be less liquid and will carry more risk than securities with short maturities. So long maturity should charge premium,hence these securities will have higher interest rates. It is plain and simple theory. Everybody loves cash or any liquid security which can be converted into cash. If you are putting your money for longer time, there is risk that rates in market might change (increase) due some factors. In that case you are loosing out the opportunity because of this earlier investment. So you should charge higher rate to bear that risk

Term structure of interest rates : It is the simplest theory which describe the shape of yield curve. Let me explain this by an example : If you have a bond with maturity of 2 years with yield Y; this yield will be equal to a yeild of a 1 year bond + expected yield on 1 year bond purchased 1 year from now.

So repharasing the example above, if 2 year yield is higher than 1 year yield, it mean that rates are going to increase in future. That is termed as rising term structure of rates. Similarly for a declining rate-term structure, it is believed that the rate are going to decrease.