Term Structure of Interest Rate
Finance

Term Structure of Interest Rate – Finance | Management Notes

Term Structure of Interest Rate
Expectation theory | Liquidity Preference theory| Market Segmentation Theory
Interest Rate | Finance | BBA  | Management Notes

Term Structure of Interest Rate

Term Structure of Interest Rate is the relationship between short term interest rate and long term interest rate. It is the interest structure between the interest rates having the same risk but different maturity time. 

What are three theories that explain the future yield curve of interest rates?

Several theories have been proposed to explain the shape of the yield curve. The three major ones are:

  1. Expectation Theory
  2. Liquidity Preference Theory
  3. Market Segmentation Theory

Expectation theory

What is the expectation theory?

Expectation theory states that the shape of the yield curve depends on the investor’s expectation about future inflation rates. This theory proposes that long term interest rates can act as a predictor of future short term interest rates. Most investors care about future interest rates especially bond investors.

For the bondholders, the future short term interest rate acts as a determining factor for the price of the bond. If the interest rate increases, the price of the bond will decrease and vice-versa. Hence, if it is expected to increase the future short term interest it is better to avoid long-term maturity bonds.


Liquidity Preference theory

What is meant by liquidity preference theory?

Liquidity Preference theory states that interest rate always depends on the investor’s preference of bond with different maturity.

What are the motives of liquidity preference?

In another word, if investor prefers more liquidity that will cause to increase in the market interest rate and if investor prefers less liquidity that will cause to decrease in the market interest rate.

Market Segmentation Theory

 

Market Segmentation Theory states that the interest rate depends on the demand and supply of short-term and long-term bonds in different market segments(money market and capital market). In other words, this theory states that each lender and each borrower has a preferred maturity, and assumes that investment is to minimize risk.

The way to minimize risk is to match the maturities of securities withholding periods. Borrowers prefer to buy long-term assets from long-term loans and short-term loans for short-term purposes.

 

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