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Theories of Interest Rate Determination

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You are a financial analyst for the CMC Corporation. This corporation predicts changes in the economy, such as interest rates, retail trends, and unemployment. Your job is to educate incoming analyst on the terminology, definitions, and uses of interest rate theories, yield curves, and predictions. In your next training session, you will cover major theories that have been developed to explain resulting yield curves and the term structure of interest rates. Prepare a training guide with the following:

1. Define and compare the following theories: expectations theory, liquidity theory, market segmentation theory, and preferred habitat hypothesis theory.
2. Explain in detail how each of the above theories explain changes in the economy.
3. Provide examples for each.

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The following posting discusses theories of interest rate determination.

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Interest Rate Theories
Expectation theory: This theory exhibits that an investor will earn same interest from an investment in one-year bond today and then roll this investment into new one-year bond in compare to two-year bond today. But this theory avoids the inherent risk of investing in bonds. For example, if an investor expects 10% short-term interest rate on the coming five-year average then the interest rate on the long-term bonds with five-year maturity will also be 10%. This theory explains that if the yield curve is upward sloping then short-term interest rates increase in future (Mishkin & Eakins, 2006). It is because, in this situation, the long-term interest rates are higher than the short-term rates and it increases the future short-term interest rates than the current short-term interest rates and vice versa (Fabozzi, 2001). This change continues in the economy and makes the average age short-term interest rate and the interest rate on long-term bonds equal. The bonds with different maturities are termed as the perfect substitutes for each other.

Liquidity theory: This theory can be defined as the theory which asserts that the forward interest rate will be higher as per the expectation and demand of the investors for investing in long-term bonds. It views similar from expectation ...

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