Expectation Theory, Liquidity Premium Theory, and Segmented Market Theory

Expectation Theory

The upward sloping curve or the inverted curve is supported by the Expectation Theory. It states that since investors want the maximum return from their short-term investments, the rate of the short term should increase in the future. Then, we must assume that long-term rates are higher than short-term ones. However, in present value terms, the return from long-term security is equal to the series of short-term securities.

Since future values from investments are the same as that of long-term returns, investors will be indifferent in choosing between them. The Expectation Theory assumes that if Capital Markets are efficient, there is no cost of a transaction. So, the investors' sole purpose is to maximize the returns. It also states that the long-term rates are a geometric means of short-term returns.

The Expectation Theory is based on the principle that given the investment horizon, all maturity combinations will yield the same amount of value. So, the issuers will not be able to alter the interest rates once it is fixed for the long run.

Liquidity Premium Theory

According to Liquidity Premium Theory, the rates of long-term bonds will remain higher than shorty term ones. As the cost of short-term debts is less, according to a firm's point of view, the firm could minimize the cost of borrowings by continually refinancing the short-term debt.

Note − In Expectation Theory the investors prefer a longer tenure bond to a shorter one. But the theory cannot explain the reason why? Liquidity premium theory answers that question.

According to the liquidity premium theory, since the investors want some extra remuneration to shift from shorter to longer period bonds, the bond issuers may provide a premium to the overall investment from their end. This is known as liquidity premium. It gives the upward sloping graph more support and bias.

Segmented Market Theory

The Segmented Market Theory assumes that the bond market is divided into various segments and each segment offers a variety of advantages. The segments are vulnerable to the ups and downs of the market and the yield depends on demands vs supply.

Most investors want to match their assets with liabilities and hence choose different options according to their needs. Investors usually require certainty of returns. The theory suggests that the borrowers do not shift from one maturity to another readily. So, the returns are based purely on demand and supply.

Note − The Segmented Market theory suggests that investors strongly prefer assets that match the liabilities and borrowers prefer to issue liabilities that match with the assets.

Updated on: 18-Aug-2021

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