Question

Name and explain briefly how theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. And elucidate as well how these theories allow us to infer the market’s expectations about the movement of future short-term interest rates from the yield curve

Answer 1

There are three main theories of term structure that explains how interest rate bonds with different terms to maturity are related, thus , these theories shows the strong connection between interest rate and yield curves .

1. Expectations Theory - in this Theory the shape of yield curve is based on market expectations of Future interest rate, in this investors are assumed to trade in an efficient market having excellent information and minimal trading risks .

2. Liquidity premium theory - it explains that as long term rates have greater risks thus , the investors would give up liquidity to get higher premium and thus they have upward sloping yield curve , where long term interest rate are more than short term interest rate.

3. Market segmentation theory- in this theory investors prefer portfolio to be liquid, thus Short term investment are preferred than long term investment. As a result, short term investment will have higher demand and cause rise in prices and lower yield and yield curve is normal.

Market expectations inference

1. It provides Information about the financial markets participants expectations, which helps in making forecast and policies, thus the participants are able to forecast future events in market .like if yield curve is downward sloping the long term interest rate are less then short term interest rate which helps participants to make future predictions.

2. These theories helps in evaluating the actual term structure of interest rates, and explain how the changes in short term interest rate affects the long term interest rate.

3. It helps central bank to apply monetary policy as the influence of policy have a direct effects on Short term interest rate. Like if the low inflation is secure , then then effects of policy in economy become more predictable.