There are four theories that explain term structure of interest rates. These are1. Segmented market theory2. Expectations theory3. Liquidity premium theory4. Preferred habitat theoryWe can see the term structure by plotting a yield curve at a point in time. The general characteristics are determined as ascending, descending, or flat. (1)1. Segmented market theoryBasic notion of segmented market theory is that many investors are very risk averse, and tend to invest in securities of a given maturity, irrespective of the return differentials because they are restricted by law, preference or custom to certain securities. Thus, what determines long-term rates is solely the supply and demand of long-term funds. Similarly, short-term rates ate determined only by supply and demand of short-term funds.For example, commercial banks, whose liabilities are mainly short-term ones, tend to invest in short-term securities, not to expose to the risk of interest increase, with a consequent fall in the market value of the bonds when liabilities are due. By contrast, life insurance companies issue many long-term contracts, and also tend to hold longer-term bonds. (2)Thus, spot rates for any maturity should exclusively depend on the relative demand for and supply of securities with that particular maturity.Segmented market is good idea and simple notion but the point is how much. The market can not be separated absolutely, short-term market will affect long-term market and vice versa in some degree. So, it’s important to find out the ingredient which affect other market.In one report said that market segmentation on the demand side suggest that changes in the expected relative supply of long-term bonds affect the shape of the yield curve. In recent years, we have had a unique situation in the Treasury security market where the expected supply of long-term relative to short-term securities has changed at discrete intervals. This has to do with the 4 1/4 percent interest rate ceiling on bonds imposed by Congress. The restrictiveness of this ceiling on Treasury debt manangement was greatly altered in March 1971 and again in February, 1976. In both cases, authority was given to the Treasury to sell long-term securities apart from the ceiling. As a result, the supply of long-term securities would be expected to increase, and indeed it did. If partial market segmentation prevails in the market for loans, the change in Treasury debt management toward a greater relative supply of long-term bonds would be expected to increase long-term interest rates relative to short-term rates.Several widely used term structure models were used to predict long-term bond yields for time periods immediately following March, 1971 and February, 1976. (3) The discrepancy between actual long rates and predicted long rates, or the residual, was used as a measure of the impact of the new information. The presence of uniformly positive residuals, where actual long rates exceed predicted long rates, would be consistent with a theory of partial market segmentation affecting the term structure of interest rates. However, residuals were not found to be predominantly positive, but rather were mixed over time. Expressed differently, there was no evidence that long-term rose relative to short-term rates after a change in the Treasury’s authority to issue long-term bonds occurred. Therefore, the results do not support a hypothesis of partial market segmentation in the Treasury security market. Based on considerations of the 4 1/4 percent interest rate ceiling and recent relaxations in this constraint, the term structure of interest rates would appear to be determined by factors other than market segmentation.(James C, Van Horne, 1980)2. Pure expectations theoryIn this theory, investors are assumed to be risk neutral and only concerned with the expected return from their investment, irrespective of its risk. Thus, the term structure of interest rates is driven by expectations about the future short-term rates.The yield curve could be either upward sloping or downward sloping, depending on whether short-term interest rates are expected to increase or to fall.Spot rates are nominal rates, so if inflation expected, the yield curve will be upward sloping, vice versa.In real market, expectation theory holds quite well. Like the equity market, investor’s expectation is the most important point that affect bonds future rates or value and it makes term structure.In this theory investors can be assumed to trade in an efficient market where they have excellent information and minimal trading costs. The importance of this theory is that the other theories presume less efficient markets. However, in this situation the yield curves are usually upward sloping, normal. On the other hand, short-term interest rates are as likely to fall as to rise. This is not consistent with the real world. The expectation theory can not explain the usual upward slope of the yield (Ali Umut Irturk, 2006) (3)3. Liquidity premium theoryThe liquidity premium theory can be regarded as an extension of the pure expectation theory. According to this theory, investors dislike the uncertainty associated with longer-term investment. The premium on long-term bonds can thus be seen as a compensation for the loss in liquidity that investor incur. So, normally longer-term rates higher than short-term rates as below figure.Figure Yield curves with liquidity premiumsWe can also say that liquidity premium is the difference between the forward rate and the expected future rate.(5)4. Preferred habitat theoryIn this theory, we assume that investors have a preferred maturity for their investments, which exactly matches the maturity of their liabilities. The returns to maturity are determined by the demand for and supply of bonds in each maturity. So, there is no reason to assume that longer-term bonds always pay a higher premium than shorter-term ones.This theory reflects both expectations of future spot rates and expectations of a liquidity premium. (6)ConclusionsWe see that economics are interested in term structure theories, because of many reasons. If we state some of these reasons:a) The accuracy of the prediction term structure theories is relatively easy to evaluate, when the actual rate term structure of interest rates is easy to observe. Here, I started the theories which are based on assumptions and principles that have applications in other branches of economic theoryb) Term structure theories explain the ways in which changes in short-term interest rates affect the levels of long-term interest rates. Economic theory states that monetary policy may have a direct effect on short-term rates, but little, if any, direct effect on longer-term rates.c) Term structure may provide information about the expectations of participants in financial markets. Thus, these expectations are of considerable interest to forecasters and policy-makers. Many economists believe that the people best able to forecast events in a market are in fact the participants in that market.At last we face this question: Which Theory is Right?We can say that Preferred Habitat Theory is the most consistent theory to the day-to-day changes in the term structure. However, if we consider the long-run, expectations of future interest rates and liquidity premium become important components of the position and shape of the yield curve (Ali Umut Irturk, 2006)In Korea Case, employing the term structure of interest rates is, indeed, useful for implementing monetary policies. The other is that central bank should also keep an eye on supply and demand for Treasury Bonds, such as evenly distributed maturity in their issuance and government funds portfolios as the risk premiums due to the continued imbalance of supply and demand increase the volatility of interest rates, which, in turn, constraints the effectiveness of monetary policies (Hyoung-Seok Lim, 2005), (7)ReferencesElton, Edwin J., Martin J. Gruber, Stephen J. Brown and William N. Goetzmann(2003), Modern Portfolio Theory and Investment Analysis, Sixth Edition, New York: John Wiley & Sons.Ali Umut Irturk (2006), Term structure of Interest Rates, University of California, Santa Barbara, California.James C. Van Horne (1980), The Term Structure: A Test of the Segmented Markets Hypothesis, Southern Economic Journal, Vol.46, No.4 (Apr., 1980)Hyoung-Seok Lim(2005), Estimation of the Term Structure of Interest Rates and its Features:Korea’s Case, Economic Analysis Vol 11, No. 2, Korea Bank, (2005)