There are three theories to explain the shape of the yield curve.
Expectation theory says the long-term yield of a financial instrument is the average of the short-term yields that are expected to occur over the life of the instrument. Thus:
• An upward yield curve means investors expect short-term yields to rise in the future
• A downward yield curve means investors expect short-term yields to decline in the future
The yield curve, therefore, changes as investors’ expectations about future short-term yields change. This explains why yields with different maturities tend to move together.
Market segmentation theory says that yields for different terms are based on supply and demand. In short, some investors have a preference for financial instruments with a certain maturity, and these preferences determine yields. The downside of market segmentation theory is that it fails to explain why yields with different maturities tend to move together.
Liquidity premium theory is a combination of expectations theory and market segmentation theory. According to this theory, the long-term yield is the average of short-term yields throughout the life of the bond plus a liquidity premium that represents the supply and demand for bonds at that term.
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