Question

Discuss the importance and application of the term-structure of interest rates for asset pricing and financial market modelling. Present various models of deriving the term-structure of interest rates with relevant variables and limitations proposed over time in the scholarly literature. Discuss desirable characteristics of models of the term-structure of interest rates based on the most evident historical examples (with data) from various markets and their implications for forecasting.

Answer 1

The term structure of interest rate in asset pricing is the relationship between interest rate and tenor or other variables. A graph of interest rate and matriities is called yeild curve. Such a graph is import for analysis of in which direction the interest rate, economy is expected to move in what maturity. The various models/ Theories are

1) Expectations Theory: In this theory, long term rates are an average of investors expected future short term rates of interest. This theory assumes that investors are indifferent to maturity.

2) Liquidity Premium Theory: This theory assumes that the long term interest rates are and average of short term rates plus the liquidity premium. This is since investors percieve long term bonds riskier than short term bonds.

3) Market Segmentation Theory: This teory derives the interest rates purely on the basis of demand and supply for various tenors of bonds or other assets.

will look for examples from various markets