Term Structure Of Interest Rates Essay

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To understand the term structure of interest rates, we study the yield curve. Yield curves are normally upward sloping reflecting a positive relationship between terms to maturity and yield to maturity, or they can be downward sloping (inverted), or flat. Yield curves may however also depict complicated shapes.
An upward sloping yield shows that long term interest rates are higher than short term interest rates. This is due to long term bonds having to compensate for the interest rate risk and inflation expectations that is associated with the longer term. Normal yield curves are usually linked with economic growth. Flat yield curves indicate that the market does not expect future short term rates to increase significantly enough to push long term yields up. Flat curves are associated with an economy nearing recession. With an inverted yield curve, future short-term rates are expected to be low enough that the long term bond rates lie below short current short term rates making them very risky to invest in. An inverted yield curve is synonymous with economic recessions.
Yield curves on their own do not provide useful information. Theories are needed to make sense of them and there are four such theories that have evolved. These are: the expectation theory, the segmented market theory, the preferred habitat theory and the liquidity premium theory. The last two theories however are closely related.
Term structures outline three facts that these theories must try
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