Another traditional theory of the term structure asserts that lenders prefer to lend short-term to avoid tying up funds for long periods of time. In other words, they have a preference for shorter maturities. At the same time, borrowers prefer to borrow long-term to lock in secure financing for long periods of time.
According to the maturity preference theory, then, borrowers have to pay a higher rate to borrow long term rather than short term to essentially bribe lenders into loaning funds for longer maturities. The extra interest is called a maturity premium.
The Fisher hypothesis, maturity preference theory, and expectations theory can coexist without problem. For example, suppose the shape of a yield curve is basically determined by expected future interest rates according to expectations theory. But where do expected future interest rates come from? According to the Fisher hypothesis, expectations regarding future interest rates are based
on expected future rates of inflation. Thus expectations theory and the Fisher hypothesis mesh quite nicely.
Furthermore, a basic yield curve determined by inflationary expectations could also accommodate maturity preference theory. All we need to do is add a maturity premium to longer term interest rates. In this view, long-term, default-free interest rates have three components, a real rate, an anticipated future inflation rate, and a maturity premium.

Yield curves have been studied by financial economists for well over a century. During this period a number of different theories have been proposed to explain why yield curves may be upward sloping at one point in time and then downward sloping or flat at another point in time. We discuss three of the most popular traditional theories of the term structure in this series of posts. We then present a modern perspective on the term structure in the following series of articles.

In previous articles, we saw how looking back at the history of returns on various types of investments gave us a useful perspective on rates of return. Similar insights are available from interest rate history. For example, at midyear 1997, short-term interest rates were about 5 percent and long- term rates were about 7 percent. We might ask, “Are these rates unusually high or low?” We discuss bills and bonds in detail in this series of posts. For now, it is enough to know that bills are short-term and bonds are long-term.
Probably the most striking feature is the fact that the highest interest rates in U.S. history occurred in the not-too-distant past. Rates began rising sharply in the 1970s, and then peaked at extraordinary levels in the early 1980s. They have generally declined since then. The other striking aspect of U.S. interest rate history is the very low short-term interest rates that prevailed from the 1930s to the 1960s. This was the result, in large part, of deliberate actions by the Federal Reserve Board to keep short-term rates low – a policy that ultimately proved unsustainable and even disastrous. Much was learned by the experience, however, and now the Fed is more concerned with controlling inflation.
With long-term rates close to 6 percent as this series of posts is written, many market observers have commented that these interest rate levels are extraordinarily low. Based on the history of interest rates, however, 6 percent may be low relative to the last 25 years, but it is not at all low compared to rates during the 170-year period from 1800 to 1970. Indeed, long-term rates would have to fall to 4 percent or lower to be considered low by historical standards (but don’t hold your breath).

Money market instruments are debt obligations that have a maturity of less than one year at the time they are originally issued. Each business day, the Wall Street Journal publishes a list of current interest rates for several categories of money market securities in its “MONEY RATES” report. We will discuss each of these interest rates and the securities they represent immediately below. First, however, we take a quick look at the history of interest rates.

The driving force toward market efficiency is simply competition and the profit motive. Investors constantly try to identify superior performing investments. Using the most advanced information processing tools available, investors and security analysts constantly appraise stock values, buying those that look even slightly undervalued and selling those that look even slightly overvalued. This constant appraisal and buying and selling activity, and the research that backs it all up, act to ensure that prices never differ much from their efficient market price.
To give you an idea of how strong the incentive is to identify superior investments, consider a large mutual fund such as the Fidelity Magellan Fund. This is the largest equity fund in the United States, with over $70 billion under management (as of mid-1999). Suppose Fidelity was able through its research to improve the performance of this fund by 20 basis points (recall that a basis point is 1 percent of 1 percent, i.e., .0001) for one year only. How much would this one-time 20-basis point improvement be worth?
The answer is .002 × $70 billion, or $140 million. Thus Fidelity would be willing to spend up to $140 million to boost the performance of this one fund by as little as 1/5 of 1 percent for a single year only. As this example shows, even relatively small performance enhancements are worth tremendous amounts of money, and thereby create the incentive to unearth relevant information and use it.
Because of this incentive, the fundamental characteristic of an efficient market is that prices are correct in the sense that they fully reflect relevant information. If and when new information comes to light, prices may change, and they may change by a lot. It just depends on the new information. However, in an efficient market, right here, right now, price is a consensus opinion of value, where that consensus is based on the information and intellect of hundreds of thousands, or even millions, of investors around the world.

In a strong-form efficient market no information of any kind, public or private, is useful in beating the market. Notice that if a market is strong-form efficient, it is necessarily weak- and semistrong-form efficient as well. Ignoring the issue of legality, it is clear that nonpublic inside information of many types would enable you to earn essentially unlimited returns, so this case is not particularly interesting. Instead the debate focuses on the first two forms.

In a semistrong-form efficient market, publicly available information of any and all kinds is of no use in beating the market.
The implications of semistrong-form efficiency are, at a minimum, semistaggering. What it literally means is that nothing in the library, for example, is of any value in earning a positive excess return. How about a firm’s financial statements? Useless. Information in the financial press? Worthless. A book? Sad to say, if the market is semistrong-form efficient, there is nothing in a book that will be of any use in beating the market. You can probably imagine that this form of market efficiency is hotly disputed.

A weak-form efficient market is one in which the information reflected in past prices and volume figures is of no value in beating the market. You probably realize immediately what is controversial about this. If past prices and volume are of no use, then technical analysis is of no use whatsoever. You might as well read tea leaves as stock price charts if the market is weak-form efficient.

Now that we have a little more precise notion of what it means to beat the market, we can be a little more precise about market efficiency. A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return. Notice the emphasis we place on “with respect to some particular information.”
For example, it seems unlikely that knowledge of Shaquille O’Neal’s free-throw shooting percentage would be of any use in beating the market. If so, we would say that the market is efficient with respect to the information in O’Neal’s free throw percentage. On the other hand, if you have prior knowledge concerning impending takeover offers, you could most definitely use that information to earn a positive excess return. Thus, the market is not efficient with regard to this information. We hasten to add that such information is probably “insider” information and insider trading is illegal (in the United States, at least). Using it might well earn you a jail cell and a stiff financial penalty.
Thus, the question of whether or not a market is efficient is meaningful only relative to some type of information. Put differently, if you are asked whether a particular market is efficient, you should always reply, “With respect to what information?” Three general types of information are particularly interesting in this context, and it is traditional to define three forms of market efficiency: (1) weak, (2) semistrong, and (3) strong.

Good question. There is a risk-return trade-off. On average at least, we expect riskier investments to have larger returns than less risky investments. So, the fact that an investment appears to have a high or low return doesn’t tell us much. We need to know if the return was high or low relative to the risk involved. Instead, to determine if an investment is superior, we need to compare excess returns. The excess return on an investment is the difference between what that investment earned and what other investments with the same risk earned. A positive excess return means that an investment has outperformed other investments of the same risk. Thus consistently earning a positive excess return is what we mean by “beating the market.”