Term Structure of Interest Rates

C

The correct answer to the question is D. The expectations hypothesis contends that the long-term rate is equal to the expected short-term rate.

The term structure of interest rates refers to the relationship between interest rates and the time to maturity of debt securities. It describes how interest rates on different maturities of bonds or other fixed-income securities are related to each other.

Now, let's examine the four given theories about the term structure of interest rates:

A. The expectations hypothesis indicates that investors have varying opinions about future interest rates. This statement is not an accurate representation of the expectations hypothesis. The expectations hypothesis suggests that the shape of the yield curve reflects the market's expectations of future interest rates. It assumes that investors expect an equal return between investing in short-term securities and continuously rolling over short-term securities. In other words, under the expectations hypothesis, the long-term interest rate is an average of expected future short-term interest rates rather than reflecting varying opinions.

B. The liquidity premium hypothesis assumes investors will give up yield to lock in longer-term interest rates. The liquidity premium hypothesis suggests that investors require additional compensation, called a liquidity premium, to hold longer-term securities rather than shorter-term securities. This theory states that investors perceive shorter-term securities as more liquid and less risky, so they are willing to accept a lower yield on shorter-term securities. In contrast, investors demand a higher yield on longer-term securities to compensate for the increased risk and illiquidity associated with these securities.

C. The segmented markets hypothesis contends that borrowers and lenders prefer particular segments of the yield curve. The segmented markets hypothesis argues that the market for debt securities is divided into separate segments based on different maturities. In this view, borrowers and lenders have preferences for specific segments of the yield curve. For example, some investors may only be interested in short-term debt, while others may prefer longer-term debt. This hypothesis suggests that the interest rates in each segment are determined independently and are not influenced by rates in other segments.

D. The expectations hypothesis contends that the long-term rate is equal to the expected short-term rate. This is the correct explanation of the expectations hypothesis. According to this theory, the long-term interest rate is equal to the market's expectation of the future short-term interest rates. In other words, investors would be indifferent between investing in a long-term bond and continuously rolling over short-term bonds with the same total maturity. The expectations hypothesis assumes that investors are forward-looking and base their investment decisions on their expectations of future interest rate movements.

In summary, the correct theory about the term structure of interest rates is the expectations hypothesis, which states that the long-term interest rate is equal to the expected short-term rate. This theory suggests that the shape of the yield curve reflects market expectations of future interest rates, rather than varying opinions, liquidity preferences, or segmented markets.