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Term Structure (LO4, CFA5) Discuss how each of the following theories for the term structure of...

Term Structure (LO4, CFA5) Discuss how each of the following theories for the term structure of interest rates could account for a downward-sloping term structure of interest rates:

a. Pure expectations

b. Maturity preference

c. Market segmentation

Solutions

Expert Solution

Term Structure of interest rates is the representation of the interest rates of similar quality bonds at different maturity periods. Graphical representation of the term structure of interest rates is known as yield curve. It helps in identifying the current state of the economy. It reflects the evaluation of the market participants regarding the monetory policies conditions and interest rates.

The yield curve is of three primary shapes:

1.Upward sloping: It implies that long term yields are higher than short term yields. It shows that an economy is in expanding mode.

2. Downward sloping: It implies that short term yields are higher than long term yields. It shows that an economy is in reccession mode.

3. Flat: It implies that there is less variation between short term yields and long term yeilds. It shows that the economy is unpredictable.

a) How pure expectation theory accounts for a downward sloping curve: Pure expectations theory predicts how the short term interest rates will be with the current long term interest rates. An increasing slop represents increasing short term gains. A downward sloping yield curve denotes that the short term yields are higher that long term yields.

b) How Maturity preference theory accounts for a downward sloping curve: According to maturity preference theory, the interest rates on short term securities are lower. Thus, short term gains have less yield than long term securities. The transaction motive of the investors tends to purchase liquid securities, thereby increasing short term yields. It leads to a downward sloping yield curve.

c) How Market segmentation theory accounts for a downward sloping curve: Market segmentation theory segments the investments to short, intermediate and long term securities and it advocates the segmentation of each market. Yield curve is the output of market segmentation theory. As per market segmentation theory, the downward slope occurs when short term securities are high yielding than long term securities. It also proposes that the banks mostly prefers short term securities than long term.


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