Match each yield curve theory with its underlying economic assumption regarding interest rate dynamics and term structure.
- Pure Expectations TheoryAsserts that long-term yields reflect market expectations of expected future short-term interest rates without requiring a liquidity premium.
- Liquidity Preference TheoryAsserts that investors require an additional yield premium for holding long-term debt due to increased sensitivity to interest rate changes.
- Market Segmentation TheoryAsserts that institutional investors operate strictly within fixed maturity sectors, making supply and demand in each segment completely independent.
- Preferred Habitat TheoryAsserts that investors have preferred maturity ranges but will shift sectors if offered a sufficient yield differential.
Answer
Pure Expectations Theory matches the assumption that long-term yields reflect market expectations of expected future short-term interest rates; Liquidity Preference Theory matches the assertion that investors require an extra yield premium for long-term debt; Market Segmentation Theory matches the assertion that institutional investors operate strictly within fixed maturity sectors; and Preferred Habitat Theory matches the assertion that investors will shift sectors if offered a sufficient yield differential.
Each yield curve theory accurately pairs with its foundational economic assumption regarding market participant behavior, liquidity premiums, and sector flexibility.
Step-by-Step Solution
Key Concept
Term Structure of Interest Rates and Yield Curve Theories
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