The theory was developed by Professor Lutz. This theory is based on certain assumptions:
(I) It is assumed that all investors have perfect knowledge about the future short term rates of interest.
(II) It is assumed that there are no taxes or other costs involved in holding or trading bonds.
(III) It is assumed that short term and long term rates of interest are adjusted for any differences arising due to risk and liquidity.
(IV) Investors are assumed to be profit maximisers. In order to maximise profit the investors shift funds freely from securities of one maturity period to another.
With these assumptions the theory comes to the conclusion that a long term interest rate is some average of the expected future rates on short term bonds. Ignoring the compound interest factor this average will be a simple average and this can be explained as follows. Suppose that the maturity period of a long period security is 3 years. The short term rate of interest in the first year when the security is issued is 4%. Suppose that expected short term rate in the second year is 5% and the expected short term rate in the third year is 6%. Then the long term rate will be the simple average of 4%, 5%, and 6% which is equal to 5%. If the long term rate of interest is an average of the short term rates of interest then it is obvious that if the short term interest rates rise the average will also rise and the long term interest will also rise. Thus the long term rate always moves in the same direction in which short term rates move. However the fluctuations in the long term rate will be lower than the fluctuations in the short term rates.
(I) It is assumed that all investors have perfect knowledge about the future short term rates of interest.
(II) It is assumed that there are no taxes or other costs involved in holding or trading bonds.
(III) It is assumed that short term and long term rates of interest are adjusted for any differences arising due to risk and liquidity.
(IV) Investors are assumed to be profit maximisers. In order to maximise profit the investors shift funds freely from securities of one maturity period to another.
With these assumptions the theory comes to the conclusion that a long term interest rate is some average of the expected future rates on short term bonds. Ignoring the compound interest factor this average will be a simple average and this can be explained as follows. Suppose that the maturity period of a long period security is 3 years. The short term rate of interest in the first year when the security is issued is 4%. Suppose that expected short term rate in the second year is 5% and the expected short term rate in the third year is 6%. Then the long term rate will be the simple average of 4%, 5%, and 6% which is equal to 5%. If the long term rate of interest is an average of the short term rates of interest then it is obvious that if the short term interest rates rise the average will also rise and the long term interest will also rise. Thus the long term rate always moves in the same direction in which short term rates move. However the fluctuations in the long term rate will be lower than the fluctuations in the short term rates.