Term structure of interest rates is the relationship between the
yields on risk-free bonds, and different maturities. In other
words, the term structure of interest rates is a a table or graph
containing the risk-free rates (or yields) for bonds of all
maturities - from very short-term bonds to very-long term
bonds.
A graphical representation of the term structure is called the
yield curve. In the yield curve, maturity is labeled on the X-axis,
and yields on the Y-axis.
Some theories of term structure are :
- Market segmentation theory - It assumes that the yield at each
maturity is determined by the supply and demand of bonds at that
maturity. Market participants stay in their preferred maturity. The
shape of the yield curve could be normal, flat, or inverted based
on the supply and demand of bonds at each maturity
- Pure expectations theory - Market expectations of future
interest rates determine the shape of the yield curve. A normal
curve (upward sloping) indicates that rates will increase in the
future, a flat curve indicates that rates will not change, and an
inverted curve (downward sloping) indicates that rates will
decrease in the future
- Liquidity preference theory - This theory assumes that bond
investors prefer short-term bonds to long-term bonds due to the
uncertainty associated with longer term bonds. This theory results
in a normal shaped curve (upward sloping) as the longer term bonds
will have higher yields to compensate investors for higher
risk
Other factors affecting interest rates :
- Inflation
- Expected inflation
- Supply and demand of money in the economy
- Central bank expectations, actions and policies