Question

2. What is the term structure of interest rates? What are some of the theories about the term structure and what do they imply about the shape of the term structure. What other things affect the different interest rates observed in the real world?

Answer 1

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