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CHAPTER 8 - TERM STRUCTURE AND VOLATILIT... > VI. EXPECTATIONS THEORIES OF THE TER...
VI. EXPECTATIONS THEORIES OF THE TERM STRUCTURE OF INTEREST RATES
So far we have described the different types of curves that analysts and portfolio managers focus on. The key curve is the spot rate curve because it is the spot rates that are used to value the cash flows of a fixed-income security. The spot rate curve is also called the term structure of interest rates, or simply term structure. Now we turn to another potential use of the term structure. Analysts and portfolio managers are interested in knowing if there is information contained in the term structure that can be used in making investment decisions. For this purpose, market participants rely on different theories about the term structure.
In Chapter 4, we explained four theories of the term structure of interest rates—pure expectations theory, liquidity preference theory, preferred habitat theory, and market segmentation theory. Unlike the market segmentation theory, the first three theories share a hypothesis about the behavior of short-term forward rates and also assume that the forward rates in current long-term bonds are closely related to the market’s expectations about future short-term rates. For this reason, the pure expectations theory, liquidity preference theory, and preferred habitat theory are referred to as expectations theories of the term structure of interest rates.