Question

Define the term of “twisting the yield curve”.  How can it happen according to (1) the market segmentation theory and (2) the pure expectations theory?

Answer 1

Answer- The yeild is a graphical presentation of the short-term and long-term structure of yeilds (interest rates) of bonds and tells the company about the relative cost of short-term and long-term debt . The yeild curve is plotted with bond yeild on the vertical axis and the years to maturity on the horizontal axis.

Twisting the yield curve means the change in the shape of the yeild curve as the relationship changes. The yield curves may be either flatter ( difference between short- and long-term rates decreases) or steeper ( difference between short- and long-term rates increases).

According to the market segmentation theory, there exists separate determinants of demand and supply for short-term and long-term securities. The interplay of these seperate determinants in distinct markets determine the shape of the yield curve.

According to the pure expectation theory, the long-term interest rates differ from short-term interest rates because financial market participants have different expectations regarding interest rates and inflation in the short-run and long-run. Yeild curve is normal when people expect the rate of interest and inflation to increase in the future and is twisted when people expect the rate of interest and inflation to decrease in the future.