The Three Theories of the Yield Curve, expectations, segmented markets and the liquidity premium

A 5 minute 59 second animated lesson on the theories of the term structure of interest rates, the explanations for why the yield curve takes the shape it does. Built for students of money, banking and financial markets, and for anyone who has wondered why a longer deposit pays a higher rate.

It starts from a single bank offering four percent for one year and four point eight for three, then works through three theories. The expectations theory makes a long rate the average of the short rates the market expects, shown with rolling two one year bonds at six and eight percent against one two year bond, an average of seven percent. The segmented markets theory treats each maturity as its own market. The lesson then points to the fact pure expectations misses, that the curve slopes up most of the time even when no rate rise is expected.

It closes on the synthesis. The liquidity premium, or preferred habitat, theory keeps the average of expected short rates and adds a term premium that grows with maturity, so it is the only one of the three that fits all the facts at once. Pair the video with the Atlas concept page for the formulas, a worked example, a quick quiz and citations.