Question

1. Use the theories of term structure of interest rates, explain why yield curve is upward sloping and downward sloping.

Answer 1

The term structure of interest rates is comprised of three basic theories. They are:

1. Expectations theory: This theoy explains as to how the shape of the yield curve is based on the expectations of an investors about future inflation. When the yield curve is flat then the current short term inflation rate is expected to be relatively unchanged. If the yield curve is downward sloping it indicates that the investors expect inflation to be lower in the future periods. In case the yield curve is upward sloping then the future inflation is expected to be higher.

2. Liquidity preference theory: It states that investors or debt instrument holders would rather prefer short term investments to mitigate interest rate risk and have greater liquidity. When the demand for liquid short term securities goes up there is an upward pressure on the yield curve. If the market expects interest rates to decline then the yield curve is downward sloping.

3. Market segmentation theory: This theory states that investors and borrowers choose their investment strategies based on their cash needs. They try to conincide the maturities of securities with their forecasted need for cash. As per the theory the shape of the yield curve is determined by the demand and supply in each market segment. For instance if investors wish to invest more funds for a long period of time while borrowers require funds for a short term, then there will be upward pressure on the yield of short term securities and downward pressure on yield of long term investments.