What theory states that the shape of the term structure of interest rates reflects additional required interest for higher risk?

The Liquidity Preference Theory is primarily focused on the preference that investors have for liquidity. This theory posits that investors demand a premium to hold longer-term securities due to the increased risk and reduced liquidity associated with them compared to short-term securities. However, it does not specifically address the additional required interest for higher risk in the term structure of interest rates.

The correct theory that explains how the shape of the term structure of interest rates incorporates a premium for higher risk associated with longer maturities is the Risk-Premium Theory. This theory identifies that as investors take on increased risk, they expect higher returns, leading to a positively sloped yield curve, which reflects additional interest for the risk of holding long-term securities.

In contrast, Market Segmentation Theory emphasizes that the bond market is made up of distinct segments where different investors operate based on their preferred maturities, and this segmentation can influence interest rates independent of risk considerations. Unbiased Expectations Theory revolves around the idea that future interest rates can be predicted from current yields but does not emphasize risk premiums explicitly.

Therefore, the Risk-Premium Theory correctly describes how risk affects the term structure of interest rates by incorporating a premium that investors require for taking on more extended risks.