Question

1. What is the term structure of interest rates, how is it related to the yield curve?
2. For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) downward sloping, (b) upward sloping, and (c) flat?
3. Briefly describe the following theories of the general shape of the yield curve: (a) expectations theory, (b) liquidity preference theory, and (c) market segmentation theory.

Answer 1

The term structure of interest rates is also known as the yield curve. This curve is plotted between the interest rates offered by similar kinds of bonds with different maturities. The yield or interest rate or coupon rate is taken in Y-axis and the time to maturity is taken in X-axis. This graph shows the relationship between yield and maturity but also hints about the health of the economy.

There are generally three types of yield curves, they are:

• The downward-sloping curve is a curve where the investors are expecting the longer-maturity bond yields to become lower than the short-maturity bond. This signalizes that there is a possibility of the economy entering into a recession as every recession is followed by yield curve inversion.
• The flat curve is a curve where the return of long-term bonds and the return of the short-term bonds are the same. This generally happens when an economy is in the transition phase. The transition may be from a expansion to a slower development or recession in economy or economy recovering from a recession.
• The upward sloping curve is a curve where the long-term bonds have higher yields than short-term ones and indicate economic expansion and an increase in inflation in the economy.

Expectations theory which is also called unbiased expectations theory suggests what short-term interest rates will be in the future based on the basis of current long-term interest rates. According to the theory, if an investor invests in two consecutive one-year bonds and in one two-year bond then the investor would earn the same interest.

Liquidity preference theory indicates that an investor who is investing in long-term maturity security should demand a higher interest rate or premium on it, as that carries greater risk. The long-term securities liquidity is lesser than short-term security which supports that additional premium should be demanded for it.

Market segmentation theory suggests that the securities with different time to maturity should be treated like separate items or investments hence long and short-term interest rates are not related to each other. It also supports the fact that the prevailing interest rates for short, intermediate, and long-term bonds should be different.