Question

Briefly outline each of the three theories for describing the shape of the term structure of interest rates (the yield curve) and discuss these theories with your classmates. Use examples if necessary. The shape of the yield curve has two major theories, one of which has three variations.Briefly outline each of the three theories for describing the shape of the term structure of interest rates (the yield curve) and discuss these theories with your classmates. Use examples if necessary. The shape of the yield curve has two major theories, one of which has three variations.

Answer 1

Three theories for describing the shape of the term structure of interest rates (the yield curve) -

1.Expectation Theory.

2.Liquidity Preference Hypothesis.

3.Segmented Market Hypothesis.

Discuss these theories with your classmates-

1. The "expectations theory" states that expectations of rising short-term interest rates are what create a positive yield curve (and vice versa).

2. The "liquidity preference hypothesis" states that investors always prefer the higher liquidity of short-term debt and therefore any deviance from a positive yield curve will only prove to be a temporary phenomenon.

3. The "segmented market hypothesis" states that different investors confine themselves to certain maturity segments, making the yield curve a reflection of prevailing investment policies.

The shape of the yield curve has two major theories, one of which has three variations-

1.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.

2.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.