Term structure of interest rates Guide, Meaning , Facts, Information and Description
Interest rates are a factor of the current rate, expected inflation and future interest rates. Term Structure of Interest Rate refers to the difference between long-term and short-term interest rate of bond or loan. Theories behind this are used to explain the phenomenons around the movement of the yield curve and interest rate in general.In most cases, the short-term interest rate are smaller than long-term interest rate. Commercial banks makes most of its money by take short-term deposits and lending it to long-term debtors.
There are three main theories attempting to explain how interest rates vary with time.
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2 Market Segmentation Theory 3 Liquidity Preference Theory |
This theory suggest that there is no relationship between long-term and short-term instruments. However, in reality, long-term and short-term interest rate tend to move together.
This theory states that debtors pay an incentive to lenders in order to obtain funds for a longer duration. This explains why interest rates for longer time periods are often higher than those for shorter time periods. This incentive is called the liquidity premium. Thus the actual interest rate is determined by two major factors:
This is an Article on Term structure of interest rates. Page Contains Information, Facts Details or Explanation Guide About Term structure of interest rates Market Expectations (Pure Expectations) Theory
This theory is also called the Expectation Hypothesis. In this theory, financial instruments of different durations are considered perfect substitutes. The Market Expectations theory states that a CD for 2 years will pay the same interest rate as a CD for 1 year followed by another CD for 1 year.
This theory suggest that interest rate on a two-year instrument is simply the multiplied product of interest rates on 2 one-year instruments. In reality, the product of short-term interest rates are almost always smaller than long-term interest rate. This is only violated in rare occasions, such as right before interest rate drops.Market Segmentation Theory
This theory is also called the Segmented Market Hypothesis. In this theory, financial instruments of different durations are not substitutable. In turn, the supply and demand in the markets for short-term and long-term instruments are determined independently. Liquidity Preference Theory
This theory is also called Preferred Habitat Hypothesis. This theory attempts to find the middle ground in former two theories and it is also the most accepted theory of the three.
See also yield curve.