Question

Explain the different term structure theories and their implications for a yield curve. Then comment on the components of interest rates and how these impact a yield curve.

Answer 1

There are three basic term structure theories of interest rates which are the Pure Expectations theory, Market Segmentation theory and liquidity preference hypothesis. The following are the implications on the yield curve and its impact of interest rates on it:

1. Pure expectation theory:

Under Pure expectations theory, the rates that have a long maturity depends on the future short term rates. This term structure is based on the investors expectations such as the future inflation rate, the future interest rates. It is based on the idea that the investor earns the same amount of interest by investing in two consecutive 1 year bonds compared to one 2 year bond. The major drawback of this theory is that it neglects the risks and assumes that investors do not have any preference of maturities. Under this theory, if the curve is flat, the short term interest rate will remain low or constant in the future. Similarly, when the rate term structure declines, the market believes that the rates would decline further.

2. Market Segmentation theory:

Under this theory, the shape of the yield curve is determined by the demand and supply of the securities for one category of maturity range. The theory states that short term and long term interest rates are not related to each other and should be viewed separately. The theory further mentions that borrowers and lenders of short-term securities and long-term securities have different characteristics. For instance, banks prefer to invest in short-term bonds while life insurance companies prefer to invest in long-term bonds.

Under the theory any kind of yield curve can occur. An upward sloping yield curve shows that when the demand for short term bonds exceeds the supply, the short term interest rates decrease and when the demand for long term bonds decreases and the supply of it increases, the long term interest rates rise. Also, when the yield curve is flat, the interest rates for the short-term and long-term securities is the same for all maturities.

3. Liquidity Preference Hypothesis

According to this theory, investors prefer liquid investments. Therefore, investors demand higher interest rates or premiums. This is because long term investments have greater risks as they are less liquid and are effected by changes in the interest rates.

Therefore, an upward sloping yield curve is caused because of future interest rates increasing or the future interest rates would fall or remain constant but the maturity premium would increase causing an upward sloping yield curve. When the yield curve is flat or downward sloping, it is mainly because of a decrease in the future short term interest rates.