Question

Take the theories about the term structure of interest rates. Explain what their differences and similarities are.

Answer 1

Term structure of interest rates is a calculation of the relationship between the yields on securities which only differ in their term to maturity. Economists and investors believe that the shape of the yield curve reflects the market's future expectation for interest rates and the conditions for monetary policy.The shape of the yield curve has two major theories, one of which has three variations.

Market Segmentation Theory: Assumes that borrowers and lenders live in specific sections of the yield curve based on their need to match assets and liabilities. The theory goes further to assume that these participants do not leave their preferred maturity section. Thus, the yield curve shape is determined by supply and demand at different maturities.The Market Segmentation Theory could be used to explain any of the three yield curve shapes.

Expectations Theories : There are three variations of the Expectations Theory, one being “pure” and the other two “biased”. All three variations share a common assumption that short term forward interest rates reflect market expectations of short term rates will be in the future.

-Pure Expectations Theory (“pure”): Only 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.Liquidity

-Preference Theory (“biased”): 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.

-Preferred Habitat Theory (“biased”): Postulates that the shape of the yield curve reflects investor expectations of future interest rates, but rejects the notion of a liquidity preference because some investors prefer longer holding periods. The Preferred Habitat Theory relies heavily on the notion that investors will match assets and liabilities.

The interest rates from U. S. dollar are invested on US Treasury securities for different maturities, and the investment processes are watched closely by many traders and investors, they assess the investment on the graph that is known as yield curve and the in a formal way, mathematical descriptions are called term structure of interest rates.In most of the yield curve, Treasury securities that are plotted, are most-common type in yield curving, the reason is these securities are assessed as risk-free, it also considered as the benchmark of in order to decide the other yields of other debts.term structure of interest rates” shows the various fields that are currently being offered on bonds of different maturities