THE RISK AND TERM STRUCTURE OF INTEREST RATES. Risk Structure of Interest Rates Default risk Liquidity Income Tax Consideration Term Structure of Interest Rates Pure Expectation Theory Market Segmentation Theory Liquidity Premium Theory. Risk Structure of Long Bonds in the US.
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1. Riskfree bonds have a lower return than risky bonds
2. High risk bonds have a higher return than low risk bonds
3. Municipal bonds have a lower return than US Government long term bonds
A. Pure Expectations Theory explains 1 and 2, but not 3.
B. Market Segmentation Theory explains 3, but not 1 and 2
C. Solution: Combine features of both Pure Expectations Theory and Market Segmentation Theory to get Liquidity Premium Theory and explain all facts
See definitions on page 131
People typically prefer short holding periods and thus have higher demand for short-term bonds, which have higher prices and lower interest rates than long bonds
Key Assumption: Bonds of different maturities are
substitutes, but are not perfect
Implication: Modifies Pure Expectations Theory
with features of Market