Question

Define the structure of interest rates and list two theories used to explain the structure.

Answer 1

The term structure of interest rates measures the relationship among yields on securities that differ only in their term to maturity. Term structure of interest rates refers to the relationship between bonds of different terms. Commonly it is also known as the yield curve, and as said depicts the interest rates of similar quality bonds at different maturities in simple terms. It is used by economists as it plays a crucial role in identifying the current state of an economy. The term structure of interest rates reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.

Interest structure usually usually are of three slopes :

• Upward sloping : This is considered to be the "normal" slope of the yield curve and signals that the economy is expanding or growth.
• Downward sloping: Aslo known as an "inverted" yield curve and signifies that the economy is in, or about to enter, a recession.
• Flat : Signals that the market is unsure about the future direction of the economy.

Two theories which is used to determine the term structure of interest are :

1. Expectation Theory : in expectation theory the market expectations for future rates will consistently impact the yield curve shape. A positively shaped curve indicates that rates will increase in the future, a flat curve signals that rates are not expected to change, and an inverted yield curve points to interest rates falling in the future.
2. Liquidity Preference theory :  this theory assumes that investors prefer short term bonds to long term bonds because of the increased uncertainty associated with a longer time horizon. Therefore, investors demand a liquidity premium for longer dated bonds. This theory has a natural bias toward a positively sloped yield curve.