Tuesday, May 26

Criticism and limitations of the expectations theory

According to Kessel (1965), the expectations theory has had widespread appeal for theoretical 

economists primarily as a result of its consistency with the way similar phenomena in other 

markets, particularly futures markets, are explained; however this hypothesis has been widely 

rejected by empirically minded economists and practical men of affairs. It was rejected by 

economists because investigators have been unable to produce evidence of a relationship 

between the term structure of interest rates and expectations of future short-term rates (Kessel, 

1965). Other economist simply have found it difficult to accept the view that long- and short- 

term securities are perfect substitutes for one another in the market. (Kessel, 1965). 

Furthermore, some empirical studies done on the government yield curve tend to go against the 

expectations theory of the term structure. Beechey et al. (2008) used cointegration methods in a 

study to test the Expectations theory of the term structure of interest rates in fourteen developed 

and developing countries. Ten of the 14 countries showed a co-integrating relationship between 

long and short interest rates, supporting the expectations theory, however, according to Beechey 

et al. (2008) there were no actual evidence of the expectations theory in emerging economies, 

which were India and South Africa in this case. Beechey et al. (2008) concluded that, the likely 

reason for the absence of the expectations theory in both countries is structural change. 

Also though it is an attractive theory because it provides a simple explanation of the behavior of 

the term structure, unfortunately it has a major shortcoming which is that it cannot explain fact 3, 

which says that yield curves usually slope upward (Mishkin, 2010) 

The typical upward slope of yield curves implies that short-term interest rates are usually 

expected to rise in the future. However, according to Mishkin(2010), in practice short-term 

interest rates are just as likely to fall as they are to rise, and so the expectations theory suggests 

that the typical yield curve should be flat rather than upward-sloping. 

Segmented Market Theory 

The segmented market theory was developed by Culbertson (1957) and is a prominent 

alternative to the expectations theory. However it is an extreme opposite of the expectations 

theory. Thus unlike the expectations theory, the key assumption here is that bonds of different 

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maturities are not substitutes at all. It is sometimes called the institutional or hedging pressure 

theory. 

Mishkin (2010) states that the segmented markets theory of the term structure sees markets for 

different-maturity bonds as completely separate and segmented, therefore, they do not interfere 

with each other. Thus the interest rate for each bond with a different maturity is then determined 

by the supply of and demand for that bond with no effects from expected returns on other bonds 

with other maturities and that the expected return from holding a bond of one maturity has no 

effect on the demand for a bond of another maturity. 

According to this theory, there are several categories of investors in the market which invest in a 

certain segment according to their liabilities with disregard to other segments (Martelli, Priaulet 

and Priaulet, 2003). Dzigbede (2003) view buttresses this point by saying that in institutional 

practices, commercial banks emphasizes liquidity thus deal in short term securities whereas 

insurance companies deal in long-term securities. 

In the segmented markets theory, the interest rate that pertains in the short term bond market is as 

a result of the market conditions of the short term bond market, and the same thing applies to the 

long term interest rate. Thus according to Mishkin (2010), differing yield curve patterns are 

accounted for by supply and demand differences associated with bonds of different maturities. 

This theory is able explain fact three, that is ‘the yield curve will typically slope upward’. All 

over the world, the demand for short term bonds is very high thus the price is also very high, 

meaning the interest rate on it falls. Demand for long term bonds is also often very low all over 

the world thus the price is low and the interest on it is high. 

Therefore just as Mishkin (2010) puts it, because in the typical situation the demand for long- 

term bonds is relatively lower than that for short-term bonds, long-term bonds will have lower 

prices and higher interest rates, and hence the yield curve will typically slope upward. 

According to Dzigbede (2003), the segmented markets theory has an upper hand over the 

expectations hypothesis in that the former determines both the short term and long term interest 

rates in the form of demand and supply of a particular security as happens in reality in a financial 

market. 

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Limitations of the segmented market theory

The segmented market theory is able to explain facts three which the expectations theory could 

not. However, it falls short when it comes to explaining facts 1and 2, which the expectation 

theory can. Since it suggests that interest rate for a bond with a given maturity is determined by 

the demand and supply for bonds in that segment with no effect from the returns on bonds in 

other segments, it therefore becomes difficult for it to be able to explain why bonds of different 

maturities tend to move together that is the fact. 

Also, as Mishkin (2010) states, because it is not clear how demand and supply for short- versus 

long-term bonds change with the level of short-term interest rates, the theory cannot explain why 

yield curves tend to slope upward when short-term interest rates are low and to be inverted when 

short-term interest rates are high (fact 2). 

According to Dzigbede (2003), the segmented market theory falls short in explaining a unique 

relationship between short-term and long term interest rates and that it is thus confined to theory 

since empirical implementation of the theory is elusive. 

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