GROUP 6

Topic 9:

Term Structure
Theories
DOROTHY KATE V. NALING

MODULE 6: ANALYSIS AND MANAGEMENT OF BONDS

Term Structure
- is often referred to as the yield
curve, and it helps investors in
making more reliable predictions
about the interest rates on bonds of
similar value that have short-,
medium-, or long-term maturities.
3 Term Structure of Interest Rate Theories
1. Expectations Theory
- Attempts to project future short-
term interest rates from current
long-term interest rates. The goal
of this theory is to help investors in
making choices based on
estimations of future interest rates.
- According to the principle, investing in two one-year
bonds requires the same return as investing in one two-
year bond, and investors can calculate short-term
securities' rates by comparing them to long-term bond
rates, which are commonly seen on government bonds.
Because it implies that two investment models (two one-
year bonds vs. one two-year bond) must produce the
same return, this theory shows an indifference for bond
maturity rates.
Calculating Expectations Theory
Ex. The present bond market provides investors with a two-year bond that pays an
interest rate of 20% while a one-year bond pays an interest rate of 18%.

1st Step 2nd Step 3rd Step 4th Step

Square the result or
Add one to the two- Divide the result by the Subtract one from the
(1.2 * 1.2= 1.44).
year bond’s interest current one-year result or (1.22 -1 = 0.22
rate. The result is 1.2. interest rate and add or 22%).
one or ((1.44 / 1.18) +1
= 1.22).
Disadvantages of
Expectations Theory

- not always a reliable tool.

- overestimates future short-

term rates.

- many factors impact short-

term and long-term bond yields.

3 Variations of Expectations Theory:
Pure Expectations
Theory
- This theory makes the assumption that
the various maturities are transferable
and that the yield curve's form is
determined by how the market
anticipates future interest rates.
Liquidity Preference
Theory
- An extension of the Pure
Expectation Theory is this theory.
According to this theory, holding
long-term debts carries more risk
than holding short-term debts.
RS
Preferred Habitat
Theory
- This theory states that investors
favor a particular investment term.
They will need to pay a premium in
order to invest beyond this time
period. The explanation for why long-
term yields are higher than short-
term yields is provided by this idea.
2. Segmented Markets Theory
- It is also referred to as market segmentation
theory. It is based on the belief that the
market for each segment of bond maturities
consists mainly of investors who have a
preference for investing in securities with
specific durations: short, medium, or long-
term.
- Bonds with varying maturities are effectively
traded in separate markets, each of which has
its own supply and demand characteristics that
determine bond yields. Due to this, it is
impossible to estimate the yields of other
groups of bonds with different maturity lengths
using the yields from one group of bonds.
 Example
Ex. To maximize profits, insurance companies frequently invest in
long-term bonds. In contrast, banks typically invest in short-term
bonds to reduce instability and safeguard their capital and liquidity.
 3. Liquidity Premium
- Investors who purchase low-liquidity securities are rewarded with a liquidity
premium. The term liquidity describes how quickly an investment may be converted
into cash.
- Bonds frequently employ the concept of liquidity premium theory. It denotes that
there is a risk-reward adaptable at effect in investing. Investors that take on more risk
can expect bigger profits. Perhaps you've probably heard the saying, "the greater the
risk, the greater the reward." Investors presume a variety of risks, and as such, they
have a potential to earn higher returns.

"The greater the risk, the greater the

reward".
How to Calculate
Liquidity
Premium?
- Using yield curve, or realized
return of two investments with
different levels of liquidity.