Wednesday, October 21, 2009


The Term Structure of Interest Rates

There are several interest rates in practice, both companies and the government offer bonds with different maturities and risk features.
Debt in a particular risk class will have its own interest rate. Yield curve shows the relationship between the yields to maturity of bonds and their maturities. It is also called the term structure of interest rates.
The upward sloping yield curve implies that the long term yields are higher than the short term yields. This is the normal shape of the yield curve.
However, many economies in high-inflation periods have witnessed the short-term yields being higher than the long term yields. The inverted yield curves result when the short-term rates are higher than the long term rates.

There are three theories that explain the yield curve or the term structure of interest rates,

  1. The expectation theory.
  2. The liquidity premium theory.
  3. The market segmentation theory.

(1).The expectation theory

This theory supports the upwards sloping yield curve since investors always expect the short-term rates to increase in the future. This implies that the long term rates will be higher than the short-term rates.

(2).The liquidity premium theory

The liquidity premium theory provides an explanation for the expectation of the investors. The prices of the long-term bonds are more sensitive than the prices of the short-term bonds to the changes in the market rates of interest.
Hence investors prefer short-term bonds to the long-term bonds. The investors will be compensated for this risk by offering higher returns on long term bonds. This extra return which is called liquidity premium, gives the yield curve its upward bias. However the yield curve could still be inverted if the declining expectations and other factors have more effect than the liquidity premium.

(3).The segmented markets theory

The market segmentation theory assume that the debt market is divided into several segment based on the maturity of debt, in each segment the yield of debt depends on the demand and supply.
Investor’s preferences of each segment arise because they want to mach the maturities of assets and liabilities to reduce the susceptibility to interest rate changes.

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