The Term Structure of Interest Rates

I. Yield Curve Yield: The single interest rate that equates the present value of a bond’s payments to the bond’s price. Yield to Maturity: A measure of the average rate of return that will be earned on a bond if held to maturity. Yield Curve:A curve showing the relationship between the yield to maturity and the maturity.

–Ascending Curve (Normal Curve) Yield Maturity –Descending Curve (Inverse Curve) Yield Maturity

–Flat Curve Yield Maturity –Humped Curve Yield Maturity

II. Theory of The Term Structure A. The Expectations Theory The forward rate equals the market consensus expectation of the future short rate, or i f 1 =E(r i ). The yield to maturity would thus be determined solely by current and expected future one-period rates (r 1, i f 1 ).

A. The Expectations Theory 1+ y n = [(1+ r 1 )(1+ 2 f 1 )... (1+ n f 1 )] 1/n. The long-term rate is the geometric mean of the short-term rates. An upward-sloping yield curve would be an indication of higher expected forward rates over time.

B. The Liquidity Preference Theory Short-term investors dominate the market so that the forward rate exceeds the expected short rate. The excess of f i over E(r i ) is known as the liquidity premium.

Yield Constant liquidity premium Constant forward rate Yield curve Constant expected short rate Maturity

Yield Rising liquidity premium Rising forward rate Rising yield curve Rising expected short rate Maturity

Yield Constant liquidity premium Falling forward rate Humped yield curve Falling expected short rate Maturity

C. The Market Segmentation Theory (Institutional Theory) Long- and short-maturity bonds are traded in essentially distinct or segmented markets, each of which finds its own equilibrium independently.

D. The Preferred Habitat Theory Investors prefer specific maturity ranges but can be induced to switch if premiums are sufficient.