Question

1) Discuss the term structure of interest rates and the yield curve: expectations model; segmented markets model; and liquidity premium and preferred habitat theories.

2) Graphically illustrate the Keynesian Transmission Mechanism (which includes the liquidity preference model). What is the purpose of the model?

1. For the graph, draw by hand and scan them or take a picture (i.e. cell phone)) and either insert it into the Word doc or attach them).

Answer 1

1) The term structure of interest is the relationship between the interest rates and the different terms/maturities

When term structure is graphed, it is known as yield curve.

Historically, yield curves have been upward sloping showing that bond yields increase as days/years to maturity increases. But there have been incidence of downward sloping as well as flat yield curves.

There are three explanations for the term structure/ shape of yoeld curve-

a) Expectations model- This model assumes that, the bonds with different maturity periods are perfect substitutes for the investors and investors are risk neutral. According to this model, the interest rate on longer term securities is the average of the shorter term securities' interest rate.

This explains the upward sloping yield curve and flat yield curve but doesn't explain downward sloping yield curve.

b) Segmented Market Model- This model assumes that the bonds with different maturity periods are not substitutes. People have preference for one type of bond and they would not switch to invest in any other bond( with different maturity period than they prefer)

According to this model, the market for bonds with different maturity periods are segmented and the interest rate for each is determined in those segmented markets.

The model says that interest rates in one market would not effect other market for bonds. The model's assumptions are very rigid and not practical.

c)Preferred Habitat Model- According to this model, the investors do have preference for bonds with specific time period but they would switch to other bond with different maturity period, if they are compensated for it. The compensation thus provided is known as liquidity premium (term premium, sometimes). The model compiles the properties of both expectations and segmented market model. If liquidity premium is 0, the model becomes expectations model because bonds are perfectly substitutable. If liquidity premium is infinity, the model becomes segmented market model, because no amount of premium can induce investors to switch their preference

This model explains all yield curve shapes