Question

Discuss Theories that have been proposed to explain key empirical regularities in the yield curve.

Answer 1

Answer : Yield Curve is a curve which shows interest on the securities on Y-Axis where as time duration of the securities on X- Axis.

Emperical Regularities Related to Yield Curve are :

• First emperical regularity involves that interest rate on different maturities tend to move together overtime.
• Second emperical regularity shows that when short term interest rate are low, yield curve are more likely to have an upward slope.
• Third emperical regularity shows that the yield curve is usually upward sloping rather than inverted.

There are three emperical theories which provides proper evidence are :

1. Pure Expectation Theory : Pure expectation theory provides emperical regularity for first two. As this theory shows that yield curve is dependent on the expectationbabout inflation. They show that interest rate directly dependent on inflation.If inflation increases in the future, yield curve should be positive. Applicability is that yield on long term securities is a function of short term rates.
2. Segmented Market Theory : In the segmented market theory slope of the yield curve dependent on demand/ Supply condition in short term/ Long term time duration. It shows the reason for upward sloping yield curve as they show short term market and long term market are different from one another. Yield curve should not follow same area of pattern. Applicability is that government securities are divided into different market segment by various financial institutions.
3. Liquidity Preference Theory : It is best suitable theory in which it studied all the effect of the yield curve. It shows the long term and short term effect of interest as well as divided the market properly and effectively. Basic of this theory is that different interest rate of different market are studied effectively and covered all the emperical regulation of it. Example : Long term rate of interest is higher than short term securities.

CRUX : Liquidity preference Theory is the best suitable theory which should have applicability and useful in ascertian the yield curve of the securities.