A STUDY IN THE MATURITY STRUCTURE OF INTEREST RATES

THIS DISSERTATION is in three parts: Part I, which contains a survey of existing theories of the term structure of interest rates; Part II, in which is developed a possible explanation along market segmentation lines, of the term structure; and Part III, in which some empirical tests of the market segmentation theory are presented. Chapter I contains a general review of monetary theory and the role the term structure plays in it. In the first part of Chapter II the literature of the early 1930's and before is surveyed. The major part of this chapter is devoted, however, to exposition and analysis of the pure expectations theory of the term structure, first propounded by Lutz and Hicks, and the pure market segmentation theory. The term structure of interest rates for default-free securities is entirely explained in the Lutz-Hicks theory by market expectations. Long-term interest rates turn out, on the assumptions made in the pure expectations theory, to be averages of the oneperiod rates expected to prevail over the relevant future. Another view of the term structure is presented in the pure market segmentation theory, which is perhaps best attributed to Culbertson. According to Culbertson, all major transactors in financial markets aim exclusively at meeting their solvency requirements at all times in the future. "Hedging" is the (near) exclusive market force. But evident overemphasis on the separateness of markets and the lack of proper micro-foundations are the major shortcomings of the market segmentation theory (qua theory), shortcomings which the model developed in Chapter V of this thesis overcomes. In Chapter III of the thesis a number of variants of the two pure theories of the term structure are appraised. Many of these are variants of the expectations theory and are distinguished by a recognition of the imperfection of the arbitrage operation assumed by Lutz and Hicks. Also evaluated in Chapter III are empirical results, due to Meiselman, Grant, and Wood, bearing on the validity of the pure expectations theory. In Chapter IV some of the (theoretical) policy implications of the various views of the term structure are discussed, along with Okun's empirical results. In Chapter V a new market segmentation theory, one based on rationalistic micromodels of consumer and institutional behavior, is developed. Quadratic stock-flow utility functions are assumed, both for households and, more importantly, financial intermediaries. The latter, financial intermediaries, are assumed to maximize their utility functions subject, not simply to their respective net worth contraints, but in addition to additional relevant constraints suggested by legal and institutional considerations. These additional constraints help explain specialization in particular markets and, to a degree, market segmentation. It is ultimately a macro-model, derived though from micro-models and with three different debt maturities, that is developed in Chapter V. Also, some of the policy implications of the model developed are spelled out in this chapter. In Chapter VI some new empirical results are presented, results which bear on the validity of the market segmentation theory and which, if not conclusive, suggest that it is less than a satisfactory explanation of the term structure of interest rates.