Liquidity Preference Theory

 

 

 

 

 

 

 

 

Structure of Interest Rates Based on Major Theories

 

Rimbu Elizabeth Titus

FIN – 655 Investments

 

Term structure theories of interest rates is explained as the calculation of relationship between the yields on securities which differ in terms of their maturity. The relationship has determinants including interest rates and yield curve. The length of your investment determines your interest rate, for example a person having investment plan of 15years is likely to get a higher interest as compared to that person with 5 years investment plan.

Terms of structure of interest rates has been explaining in four major theories as follows.

Liquidity Preference Theory

This theory suggest that an investor should demand for investments with long term maturity with higher interest rates that have greater risks since all factors are equal, they like cash or liquid investments. Investors don’t like short term securities since they have a higher liquidity unlike long-term securities which keeps investor’s money kept for a long duration (Chen 2022). Liquidity rules prevent an investor from selling the bond anytime they wish. Investors prefer Liquidity because short term debt securities acquire less price change as compared to long term debt securities. Investors need motivation to aid in payments of risks involved like price risk and liquidity risks.

Market Segmentation Theory

Market segmentation theory postulates that short term interest rates are not related in any way with long term interest rates, that interest rates in long- and short-term bonds should be viewed independently as entities existing in different markets for debt securities. This theory concludes that the yield curve is attained by demand and supply of a given market or debt security maturity and that they yield for one group of maturity cannot be compared to another group of maturity (Tracy, 2019). The theory holds a belief that every group of bond securities have investors who want to invest in securities for a given period of time, either short, intermediate or long term. It also states that buyers and sellers of short-term securities have characteristics different from those engaging in long term securities.

Theory of Expectations

This theory foresees the future expected interest rates using the current interest rates. Expectations theory implies that an entity or any person who has committed his money for return gains is likely to get same rates for interest by investment of having three consecutive one-year bond investments or investing in one three years investment bond (Malcolm 2022). Management in active bond portfolios means that the manager participates actively in running the organization and manages the portfolios. The portfolio managers actively participate in choosing a bond that is highly performing and is likely to hit a higher benchmark index performance. Passive portfolio bond management is controlled by a manager that only invests in a pool of bonds that have been chosen to suit the performance of benchmarks index. Passive management of portfolio copies the investor’s ideas of a given index to achieve similar outcomes.

Immunization of portfolio is a way of matching the time of liabilities and assets to solve risks of interest rates on net worth over time. Businesses and investors use this strategy with varied choices to protect their overall returns against risks of interest rates. Portfolio immunization targets to balance the effects interest rates have on price returns and investments returns of a bond.

 

 

 

 

Referencing

Chen, J. (2022, February 8). Liquidity preference theory. Investopedia. Retrieved May 16, 2022, from https://www.investopedia.com/terms/l/liquiditypreference.asp

Tracy, P. (2019, October 1). Market segmentation theory definition & example. InvestingAnswers. Retrieved May 16, 2022, from https://investinganswers.com/dictionary/m/market-segmentation-theory

Malcolm, T. (2022, April 14). What is an expectation theory? Smart Capital Mind. Retrieved May 16, 2022, from https://www.smartcapitalmind.com/what-is-an-expectation-theory.htm