Term structure of interest rates

Question 1

Why do interest rates vary over time

Answer 1

• Supply and Demand
• Base rates
• Interest rates in other countries
• Expected future inflation
• Tax rates
• Risk associated with changes in interest rates

Question 2

Expectations theory

Answer 2

• The relative attraction of short and longer-term investments will vary according to expectations of future movements in interest rates
• An expectation of a fall in interest rates will make short-term investments less attractive and long-term investments more attractive. Yields on short-term investments will rise and yields on long term investments will fall. And vice versa

Question 3

Liquidity preference theory

Answer 3

Longer-dated bonds are more sensitive to interest rate movements than short-dated bonds

It is assumed that risk averse investors will require compensation (in the form of yields) for the greater risk on longer bonds

Question 4

Market segmentation theory

Answer 4

Bonds of different terms are attractive to different investors, who will choose assets that are similar to their liabilities. The demand for bonds will therefor differ for different terms

The supply of bonds will also vary by term, as governments and companies’s strategies may not corresponds to the investor’s requirements

The market segmentation hypothesis argues that the term structure emerges from these different forces of supply and demand