Finance Fixed Income

Yield Curve Theories

Article collaboration with: Vrushank Setty

Setting the Context: Understanding and being able to predict how the Yield Curve is going to evolve over time, would enable investors to make better informed decisions for their capital allocations. In academia and Finance literature, certain popular theories have emerged which take a shot at explaining the behaviour of the Yield Curve over time for different maturities.

Theories explaining the evolution of the Yield Curve

I) Unbiased Expectation Theory: Imagine a world with ZERO biases, everything you expect is going to transpire in exactly the same fashion. A hundred percent prescience of how the world is going to evolve, well at least with respect to how the Yield Curve is going to evolve, that’s the basic presumption of the “Unbiased Expectation Theory”. According to this theory, as the name suggests there is no bias between the forward expected rate curve and the future realised spot curve. That is, the spot curve is eventually going to take the exact form of the forward rates we’re expecting currently. In that scenario, there cannot be any risk premium demanded, because things are going exactly as expected, yeah?

II) Local Expectation Theory: This theory is derived from Unbiased Expectation Theory and takes on the approach that investors are risk-neutral. In a risk-neutral world, investors are not affected by uncertainty and risk premium does not exist. Every security is risk-free and yield is the risk-free rate of return for that particular security. This theory also states that the forward rate is the unbiased predictor of the future spot rate in the short-term.

For example: Investors are indifferent between buying a bond that has a maturity of 5 years and holding it for 3 years vs buying a series of 3 one year bonds.

The only difference between Unbiased Expectation Theory and Local Expectation Theory is that the latter can be applied to the world characterised by risk in the long-term. However, requires risk premium not to exist in the short holding periods.

III) Liquidity Preference Theory: The existence of liquidity premium on long term bonds makes the yield curve upward sloping. This theory assumes investors to be risk-averse.

For example, Let’s take US Treasury that offers bond with a maturity of 30 years. If an investor buys this bond but has an investment horizon shorter than 30 years would require a premium for holding this bond and taking the risk that the yield curve might change before maturity and sell at an uncertain price. The higher return would be the effect of the liquidity premium.

IV) Market Segmented Theory: This theory argues that the yield curves are not a reflection of expected spot rates or liquidity premium but rather a function of supply and demand for funds of a particular maturity. Lenders and borrowers are allowed to influence the shape of the yield curve. The term market segmented theory is called that way because each maturity is thought of as a segmented market in which yield premium can be determined independently from yields that prevail in other maturity segments, by sheer forces of supply and demand.

This theory assumes that market participants are either unwilling or unable to invest in anything other than the securities of their preferred maturity.

V) Preferred habitat theory: This theory takes on the side of segmented market theory as well as expectations theory and is more closely aligned with the real-world phenomena to explain the term structure of interest rates. This theory also states that if the additional returns to be gained are large enough then the institutions and the agents will be willing to deviate from their preferred habitats.

Example: If excess returns expected from buying short term securities is large enough, life insurance companies may restrict themselves from buying only long-term securities and place a large part of their portfolio on the short-term interest rates.

Additional risk leads to additional expected return is what this theory believes in and in turn drives the term structure of interest rates.