The term structure of interest ratesmarket interest rates at various maturitiesis a vital input into the valuation of many financial products. The term structure of interest rates measures the relationship among the yields on defaultfree securities that differ only in their term to maturity. The determinants of this relationship have long been a topic of concern for economists. Chapter 4 interest rate measurement and behavior chapter 5. A theory of the term structure of interest rates article pdf available in econometrica 532. The theories that attempt to explain the term structure of interest rates are. Then the traditional theory will be recast in terms consistent with.
Term structure of interest rates this section focuses on variations in yields among financial instruments with common default risks, liquidity, information cost, and taxation characteristics but with different maturities. A shortterm interest rate is determined by demand for and supply of sortterm securities in the shortterm security. For instance, in november 2004, the yield curve for uk government bonds was partially inverted. This means that long term interest rates are an unbiased predictor. The term structure of interest rates, spot rates, and yield to maturity in the main body of this chapter, we have assumed that the interest rate is constant over all future periods. There are three popular theories to explain the term structure of interest rates. A theory of the term structure of interest rates semantic scholar. The yield curve usually slopes upward downward when shortterm interest rates are low high fact 2.
Financial economics term structure if interest rates are expected to stay constant r 1 e r 1, the yield curve will be upward sloping, r 2 r 1. Below theories of term structure of interest rates helps finance executives to understand expected inflation and interest rates. The general pattern is that shorter maturities have lower interest rates than longer maturities. The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. Bonds and the term structure of interest rates 2 i. As a result, term structure theory is often described as the theory of the yield curve. Term structure of interest rates theories bbalectures. This is not the same expectational relationship as that emphasized by keynes in the general theory. The information content of the term structure of interest rates oecd. There are three variations of the expectations theory, one being pure and the other two biased. Term structure of interest rate definition, theories.
The variation in yield for related instruments differing in maturities is known as the term structure of interest rates. The bestknown theory regarding yield curves is based on bond investors and issuers expectations about future shortterm interest rates. It enables investors to quickly compare the yields offered on shortterm, mediumterm and longterm bonds. Evidence from the term structure of interest rates.
Appendix 5a the term structure of interest rates, spot. Interest rates on bonds of different maturities tend to move together fact 1. Traditional theories of the term structure of interest rates j. Interest rate is defined as the cost of borrowing funds or the price paid for the rental funds. Interest rate measurement and behavior chapter 5 the risk and term structure of interest rates level of interest rates fisher effect risk free rate. The term structure of interest rates shows the various yields that are currently being offered on bonds of different maturities. Backus d, zin s 1993 long memory inflation uncertainty. The yield of a bond depends on the price of the bond, which in turn, depends on the supply and demand for a particular bond issue. The idea is that market participants choose maturities to maximize outcomes over some known time horizon investors maximize their expected rate of return i. Factors determining the term structure of interest rates 3. Note that the chart does not plot coupon rates against a range of maturities that graph is called the spot curve the term structure of interest rates. The term structure relation expresses the longterm interest rate as a weighted average of current and expected shortterm rates, thus implying that the variance of the long rate is bounded by the variance of the short rate. Introduction term structure of interest rates refers to the relationship between interest rates and their maturity periods.
The term structure of interest rates comprises the interest rates of riskfree zerocoup. The expectations theory of the term structure and short. There are a number of theories to explain the nature and determination of the rate of interest. The theory of the term structure of interest rates, although it has not figured in the renowned controversies over the theory of. The term structure of interest rates generally refers to the structure of spot and forward ratesnot the coupon yield curve. Pdf a theory of the term structure of interest rates researchgate. The structure of interest rates, this journal, lv nov. If shortterm rates are high, the yield curve tends to slope down.
Explain what is meant by the term structure of interest rates. The goal of this reading is to explain the term structure and interest rate dynamicsthat is, the process by which the yields and prices of bonds evolve over time. Yield curves and interest rates are one of the vital term structure. This pdf is a selection from an outofprint volume from the national. They are pertinent in understanding why and how are the yield curves so shaped.
Theories of term structure of interest rates there are four theories namely expectation theory, market segment theory, liquidity preference theory and preferred habitat theory that explains the shape of yield curve. Three theories that explain the shape of the term structure of interest rate are the unbiased expectations theory, the liquidity premium theory and the market segmentation theory. As the focus in this dissertation is on shortterm interest rates, longterm interest rates will be mentioned only briefly. The markets anticipation of falling interest rates causes such incidents. Pdf this paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. Theories of the term structure of interest rates finance essay. It is the interest rate difference on fixed income securities due to differences in time. A theory of the term structure of interest rates request pdf.
The opposite position shortterm interest rates higher than longterm can also occur. When you compute forward rates from the ratio of spot rates, as we have described in this chapter, you are applying a purely mathematical relationship, implied from the definition of a spot interest rate. Any study of the term structure is incomplete without its background theories. Qtsms allow for strictly positive nominal interest rates without imposing restrictions on the correlation structure of state variables. All three variations share a common assumption that short term forward interest rates reflect market expectations of short term rates will be in the future. If sub sequent research lends credence to this theory, economists may give more emphasis to risk aversion in constructing theories of other aspects of financial. Monetary policy and the term structure of interest rates. Abstractthis paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. It assumes operations based upon longrun expectations regarding shortterm rates, while keyness approach is. The yield curve plots the relationship between interest rates longterm rates and shortterm rates and terms to maturity. Empirical research on models of the term structure of interest rates have generally. Understanding the term structure of interest rates.
The historical patterns of relationships between shortterm and longterm yields have long intrigued both economic theorists and investment analysts. Expectations theory of term structure of interest rates states that market participants and the market forces as well will determine the return from holding security where the return from holding an nperiod bond equals the average. The cyclical behavior of the term structure of interest. Under this theory, forward rates are determined solely by expected future spot rates. Understanding the term structure of interest rates st. By offering a complete schedule of interest rates across time, the term structure. Despite the considerable attention devoted to the question, the theory of the term structure of interest rates is by no means settled. In the present article it is shown that a similar result is applicable to the termstructure puzzle.
Lecture 7 term structure theories, interest rate risk. Unlike first 2 theories which treat market as a whole this theory treats market as if made up of segments. Heath d, jarrow r, morton a 1992 bond pricing and term structure of interest rates. Theories of the term structure of interest rates finance. Economists are interested in term structure theory for a number of reasons. The risk and term structure of interest rates this lecture. We discuss 5 different theories of the term structure of interest rates. View notes lecture 7 term structure theories, interest rate risk. Pdf a theory of the term structure of interest rates. Most times, the yield curve is upward sloping fact 3.
Many of the factors traditionally mentioned as influencing the term structure are thus included in a. The term structure of interest rates trinity college dublin. In this model, anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices. The term structure of interest rates refers to the relationship between market rates of interest on short term and longterm securities. Moreover, the term structure of interest rates is one of the most crucial research areas for economists cox et al. Expectations theory and term structure of interest rates. As far as the determinants of shortterm interest rates are concerned, the basic question in this dissertation is whether they are determined by market forces or as a policy variable. The unbiased expectations theory or pure expectations theory argues that it is investors expectations of future interest rates that determine the shape of the interest rate term structure.
Expectations theory states that current long term rates can be used to predict short term rates of future. One does observe an upwardsloping yield curve more often than a downwardsloping yield curve. The yield curve plots the effective annual yield against the number of. One meason is that since the actual term structure of interest rates is easy to observe, the accuracy of the predictions of different term structure theories is relatively easy to. The expectations theory of the term structure holds that the longterm interest rate is a weighted average of present and expected future shortterm interest rates. The yield curve shows how yield changes with time to maturity it is a graphical representation of the term structure of interest rates. Three theories are proposed to explain the evolution of spot rate curves. The following term structure of interest rates theories is vital in this regard expectations theory. Interest is paid because capital is productive and is equal to the marginal product.
Conard, 4n introduction to the theory of interest, university of california press, 1959, part iii. Each of the different theories of the term structure has certain implications for the shape of the yield curve as well as the interpretation of forward rates. We covered the essentials of this chapter in lecture notes 3. Interest rates on bonds of differing maturities tend to move together when shortterm interest rates are low, the yield curve tends to slope up. This theory simply states that the marginal productivity of capital determines the rate of interest. Expectations theory states that current longterm rates can be used to predict short term rates of future. Expectations theory of term structure of interest rates states that market participants and the market forces as well will determine the return from holding security where the return from holding an nperiod bond equals the average return expected.
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