Question

What is the term structure of interest rates? Define it and explain main theories behind it.

Answer 1

The term structure of interest rates shows the various yields that are currently being offered on bonds of different maturities. It enables investors to quickly compare the yields offered on short term,medium term and long term.

Note that the chart does not plot coupon rates against a range of maturities that graph is called the spot curve.

The term structure of interest rates takes three primary shapes. If short term yields are lower than long term yields,the curve slopes upwards and the curve is called the positive.

in general when the term structure of interest rates curve ius positive this indicates that investors desire a higher rate of return for taking the increased risk of lending their money for a longer time period.

Many economist says that a steep positive curve means that investors expect strong future economic growth with higher future inflation , and that a sharply inverted curve means that investors expect sluggish economic growth with lower future inflation . A flat curve generally indicates that investors are unsure about future economic growth and inflation.

There are three central theories that attempt to explain why yield curves are shaped the way they are.

1. The 'expectations theory' says that expectations of increasing short term interest rates are what create a normal curve and vice versa.

2. The 'liquidity preference hypothesis' says that investors always prefer the higher liquidity of short term debt and therefore any deviance from a normal curve will only prove to be a temporary phenomenon.

3. The 'segmented market hypothesis' says that different investors adhere to specific maturity segments . This means that a term structure of interest rates is a reflection of prevailing investment policies.