Least Consistent Theory of the Term Structure of Interest Rates

A

To determine which theory of the term structure of interest rates the given yield curve is least consistent with, let's examine each theory and its implications.

1. Pure expectations theory: The pure expectations theory suggests that the shape of the yield curve is solely determined by investors' expectations of future short-term interest rates. According to this theory, the yield curve should reflect market expectations of future interest rate movements. If investors expect interest rates to remain stable in the future, the yield curve should be flat.

In the given scenario, there is a widely accepted belief that 1-year interest rates will remain stable at their current level of 3.25%. However, the yield curve derived from spot rates on U.S. Treasury securities is upward sloping, indicating higher interest rates for longer maturities. This contradicts the expectations of stable interest rates and is inconsistent with the pure expectations theory. Therefore, option A (Pure expectations) is not the correct answer.

2. Liquidity preference theory: The liquidity preference theory suggests that investors demand a premium for longer-maturity securities to compensate for the increased risk associated with tying up their funds for a longer period. According to this theory, the yield curve is upward sloping, indicating higher interest rates for longer maturities.

In the given scenario, the yield curve is indeed upward sloping, with higher interest rates for longer maturities. This is consistent with the liquidity preference theory. Therefore, option B (Liquidity preference) is not the correct answer.

3. Market segmentation theory: The market segmentation theory argues that different investors have preferences for specific maturity segments of the yield curve. These preferences may be due to regulatory constraints, investment policies, or other factors. According to this theory, the shape of the yield curve is a result of the supply and demand dynamics within each maturity segment, rather than expectations or liquidity preferences.

In the given scenario, the yield curve is not inconsistent with the market segmentation theory. The shape of the curve could be explained by various market participants with different preferences and demands for specific maturity segments. Therefore, option C (Market segmentation) is the correct answer as it is the theory least consistent with the given yield curve.

In conclusion, the given yield curve is least consistent with the market segmentation theory (option C). The shape of the curve, which is upward sloping, suggests that it is more influenced by liquidity preferences and market expectations rather than market segmentation.