What are three theories for describing the shape of the term structure of interest rates (the yield curve)? Briefly describe each theory.

The expectations theory states that the shape of the yield curve represents the investor’s anticipation regarding the future interest rates. As per this theory, the yield curve will be upward sloping when the interest rates are expected to rise.

The liquidity preference theory states that investors prefer short-term bonds as they are more liquid than long-term bonds. This theory states that the yield curve will be upward sloping as the long-term bonds will provide extra interest to attract investors to hold the bonds for a long period.

The hedging pressure theory states that the different investors hold the bonds for different maturity periods. As per this theory, the shape of the yield curve will be based on the period for which funds are invested and the preferences of the investors.