Finance

Theories of Term Structure

Theories of Term Structure

Interest Rates are a barometer of the Economy and an instrument for its control. The term structure of interest rates (the Yield Curve) represents the interest rates at different maturities of similar quality bonds. It shows the yield that an investor is expecting to earn if he lends his money for a given amount of time. It is an effective economic analytical tool.

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Usually, the yield curve looks something as above. The long-term returns tend to be higher than the short-term interest rates. It can also sometimes be inverted in nature, depicting lower interest rates for a higher term to maturity – usually an indicator of an upcoming Recession/downturn. This article will look at some Theories of Term Structure that led to the resultant Yield Curve theory.

Theories:

  • Market Segmentation Theory: States that short-term and long-term interest rates are not related to each other. For short, medium, and long-term bonds, the prevailing interest rates should be regarded separately as items for numerous debt securities markets. In general, banks prefer short-term securities, while insurance companies generally favor long-term securities.
    Notice the gap between the yields of different treasury maturities in the chart given below:

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The size of the gap has varied over time. Essentially, Market Segmentation theory says that it’s not necessary that 10-year bonds always pay, say 1% lower yields than 15-year bonds. Two maturities have a different market and as such, they have different demand and supply dynamics.

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  • Expectations Theories: There are 3 variations of this theory. All assuming that short term forward rates reflect market expectations of what short term rates would be in the future.

Pure Expectations Theory (“pure”): It suggests that an investor earns the same interest through two consecutive one-year bond investments compared to one two-year bond investing today. The theory is also known as the “unbiased expectations theory”. A positive curve suggests that future interest rates will increase, a flat curve indicates that rates will not change and an inverted yield curve indicates future rate declines.

Liquidity Preference Theory (“biased”): Assumes that investors prefer short-term bonds over long-term ones because the long-term horizon is more uncertain. Therefore, investors demand a liquidity premium for longer-dated bonds. This theory has a natural bias toward a positively sloped yield curve. The reasoning behind this theory is that all other factors being equal, investors prefer cash or other highly liquid holdings – hence the name. The motives behind preferring cash over more illiquid assets are:

      • Speculation: Putting money into an illiquid asset means tying up capital and an increased risk of missing out on better opportunities.
      • Precaution: For unforeseen circumstances. Investors give up liquidity in exchange for higher interest rates if higher rates are offered.
      • Transactions: To guarantee to have sufficient liquidity to meet basic and daily needs. Meeting short term obligations, daily operations, buying groceries.

 Preferred Habitat Theory (“biased”): Says that investors are only willing to buy outside their “habitat” if they are offered enough risk premium (higher yield) compared to their preferred habitat. If all else is equal, investors will prefer the short-term maturities over longer-terms, and hence for investors to choose long-term bonds, the premium should be higher.

 

Author:  Aman Aggarwal

About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.

 

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