DEFINITION of 'Expectations Theory'

The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you
would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year
later compared to buying a two-year bond today.

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DEFINITION of 'Liquidity Preference Theory'

The idea that investors demand a premium for securities with longer maturities, which entail greater risk, because they would prefer to hold
cash, which entails less risk. The more liquid an investment, the easier it is to sell quickly for its full value. Because interest rates are more
volatile in the short term, the premium on short- versus medium-term securities will be greater than the premium on medium- versus longterm securities. For example, a three-year Treasury note might pay 1% interest, a 10-year treasury note might pay 3% interest and a 30-year
treasury bond might pay 4% interest.

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NVESTOPEDIA EXPLAINS 'Preferred Habitat Theory'

The preferred habitat theory is an expansion on the expectations theory which suggests that long-term yields are an estimate of the future
expected short-term yields. The reasoning behind the expectations theory is that bond investors only care about yield and are willing to buy
bonds of any maturity, which in theory would mean a flat term structure unless expectations are for rising rates. The preferred habitat theory
expands on the expectation theory by saying that bond investor's care about both maturity and return. It suggests that short-term
yields will almost always be lower than long-term yields due to an added premium needed to entice bond investors to purchase not only
longer term bonds, but bonds outside of their maturity preference.

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Market segmentation theory posits that the behavior of short-term and long-term interest rates are mutually exclusive.
How it works/Example:
Market segmentation theory suggests that the behavior of short-term interest rates is wholly unrelated to the behavior of long-term interest rates. In
other words, a change in one is in no way indicative of an immediate change in the other. Both must be analyzed independently. Accordingly, the yield
curvereflects the market supply and demand for Treasury bonds of a certain maturity only.
Why it Matters:

Market segmentation theory suggests that it is impossible to predict future interest rate outcomes based on short-term interest rates. Moreover, longterm interest rates (for example, the rate of the 30-year Treasury bond) only express market expectations and do not indicate that a definite
outcome willoccur.

According to market segmentation theory, investors and borrowers do not consider their
short-term investments or borrowings as substitutes for long-term ones. This lack of
substitutability keeps interest rates of differing maturities independent of one another. If
investors or borrowers considered alternative maturities as substitutes, they may switch
between maturities. However, if investors and borrowers switch between maturities in
response to interest rate changes, interest rates for different maturities would no longer be
independent of each other. An interest rate change for one maturity would affect demand
andsupply, and hence interest rates, for other maturities.