Question

Discuss three theories of Term structure of interest rates. Which theories support its current shape? Draw the current shape and define Term structure of interest rates. Please answer in essay format and provide details.

Answer 1

Term structure of interest rate means the relationship between market rates of short and long term securities.

Theories of term structure of interest rates are as below :

1. Segmented Markets Theory : Under this theory yields are not determined by liquidity premium or expected spot rates, rather these are determined by preferences of borrowers and lenders. Under this theory there is different demand and supply dynamics at every maturity at yield curve whose shape is determined by the borrowers and lender at that specific maturity.

2. Liquidity Preference Theory : Under this theory forward rates are determined by investors expectations of future spot rates and adding a liquidity premium to compensate investor for exposure to interest rate risk at high end of maturity. Hence yield curve is upward sloping thereby reflecting the high premiums and yields at high maturity of the curve.

3. Preferred Habitat Theory : Under this theory forward rate represents expected future spot rates plus premium but it also suggests that whenever there is imbalance of demand and supply at given maturity range this will induce lendera and borrowers to shift from their preferred habitats to profit from opportunity. Hence risk premiums can be high or low at any end of the curve.

Curve in blue represents the current yield curve in Uniteed States. As it can be seen it is low and lower end of maturity while high at high end of the maturities. The shape of this curve can be explained through Liquidity preference theory where high end securities fetch high premium due to high associated risks .

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