The Risk and Term Structure of Interest Rates 121 Three-Month Bills (Short-Term) Three-to-Five-Year Averages FIGURE 6-4 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 Long-Term Bond Average 1964 22 20 18 16 14 12 10 1962 Interest Rate (%) CHAPTER Movements over Time of Interest Rates on Government of Canada Bonds with Different Maturities, 1962 2008 Source: Statistics Canada CANSIM II Series V122531, V122485, and V122487 upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted Yield curves almost always slope upward, like the yield curves in the Financial News box Four theories have been put forward to explain the term structure of interest rates, that is, the relationship among interest rates on bonds of different maturities reflected in yield-curve patterns: (1) the expectations theory, (2) the segmented markets theory, (3) the liquidity premium theory, and (4) the preferred habitat theory The expectations theory does a good job of explaining the first two facts on our list but not the third The segmented markets theory can explain fact but not the other two facts, which are well explained by the expectations theory Because each theory explains facts that the others cannot, a natural way to seek a better understanding of the term structure is to combine features of all four theories, which leads us to the liquidity premium and preferred habitat theories, which can explain all three facts If the liquidity premium and preferred habitat theories a better job of explaining the facts and are hence the most widely accepted theories, why we spend time discussing the other two theories? There are two reasons First, the ideas in these two theories provide the groundwork for the liquidity premium and preferred habitat theories Second, it is important to see how economists modify theories to improve them when they find that the predicted results are inconsistent with the empirical evidence Expectations Theory The expectations theory of the term structure states the following commonsense proposition: the interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the longterm bond For example, if people expect that short-term interest rates will be 10% on average over the coming five years, the expectations theory predicts that the interest rate on bonds with five years to maturity will be 10% too If short-term interest rates were expected to rise even higher after this five-year