4 Theories of Term Structure: 1. Pure Expectations Theory
2. Liquidity Premium Theory
4. Preferred Habitat TheoryThis hybrid theory combines elements of the other three. Borrower & lenders do hold strong preferences for particular maturities. The yield curve will not conform strictly to the predictions of the other three theories. The Risk Structure of Interest Rates A security issuer defaults if it fails to meet the terms of the contractual agreement in full. Embedded in the yield of risky securities is a premium to compensate lenders for default risk. Risk Premium: additional yield contained in financial instruments to compensate lenders for default risk.