Term Structure of Interest Rates

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TermStructure of Interest Rates

Factabout interest rates

  1. The yield curve slopes upwards (normal curve) if long-range rates are higher than short-range rates

  2. The curve slopes downwards (inverted curve) if long-range yield rates are lower than the short-range rates.

  3. The yield curve becomes flat when there is a small or not variation at all between the short-term and long-term yield rates (Choudhry, 2011).

Normalcurve

Thegraph agrees with the liquidity preference theory the long-rangeloan rates are higher compared to the short-range loan rates possiblybecause of the wish of investors for a greater liquidity. Therefore,a premium is presented so as to encourage enough long-term venture(Malkiel, 2015).The expectation concept can also be used to explain the graph in thesense that the curve results from increasing inflationaryexpectations.

Invertedcurve

Twotheories can be used to explain this curve i.e. the expectationtheory and market segmentation theory. Based on the first theory, theinverted curve is as a result of decreasing inflationary expectations(Choudhry,2011).However, using the market segmentation theory, the curve is as aresult of a scenario where the supply for short-term loans is lowerthan the demand when the need for long-range funds is lower than theamount supplied.

Comparisonbetween the two sets of curves

Thefirst yield curves show expected higher future interest rates whilethe second set of yield curves show expected lower future interestrates. Using the expectation theory, the second set of curves(inverted curves) shows an oncoming economic slowdown while the firstset of curves (normal curves) shows a strengthening economy(Ang, Bekaert, &amp Wei, 2008).Therefore, the expectation theory shows a higher prediction power ofthe interest rates in predicting, for example, the 2008/2009financial crisis.

Reference

Ang,A., Bekaert, G., &amp Wei, M. (2008). The term structure of realrates and expected inflation. TheJournal of Finance,63(2),797-849.

Choudhry,M. (2011). Analyzingand interpreting the yield curve.John Wiley &amp Sons, Inc..

Malkiel,B. G. (2015). Termstructure of interest rates: expectations and behavior patterns.Princeton University Press.