Question

Define term structure of interest rates and be able to use diagrams to explain and discuss the 4 theories of term structure.

Answer 1

Term structure of interest rate shows different yields on bonds at different maturities, the maturities of bonds being long , short and medium. The yield curve represents this relation graphically. There are three types of yield curves which are explained with the diagram

a)

This is known as the normal curve where the yield of shorter term is less than the yield of longer term. This is the positive yield curve (upward sloping)

This is the curve which happens when the short term yield is more than the long term yield. It is known as the inverted yield curve. This curve may lead to recession .

The last is the flat line

In flat line the yield from both long term and short term bonds is almost the same with slight variation.

Theories of term structure

To explain the term structure and the diagrams ,we have 4 theories of term structure

1) The segmented market theory explains that different investors and individuals prefer different maturity bonds depending on their needs and other investment policies in the economy.

2) Expectations hypothesis theory states that if the future interest rates are expected to rise, there would exist higher yield to maturity for longer term bonds that is explained by the positibe yield curve and if the rates are to be decreased in future, we have the decling curve or negative sloped yield curve as shown.

3) Liquidity premium theory states that the longer the yield to maturity more will be the interest rate . Since the term to maturity is longer , it implies more risks involved and hence the premium should be higher. Eg: treasury bills have lesser risks because of being the government bonds and hence have lesser yield.

4) Preferred habitat theory is similar to market segmentation theory but here the difference is that the investors tend to prefer a different range other than their preferred habitat or their preferred type of bonds only when they receive a higher yield elsewhere. It also states that mostly short term bonds are preferred to long term bonds.

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