Term Structure of Interest Rate

1588 WordsDec 20, 20127 Pages
WITH REFERENCE TO THE UK EXPLAIN THE CONCEPT OF THE TERM STRUCTURE OF INTEREST? WHAT INFLUENCE DOES THE BANK OF ENGLAND HAVE OVER THE TERM STRUCTURE AND WHY IS IT IMPORTANT FOR MONETARY POLICY To understand the term structure of interest rate we need to elaborate how interest rates function and how they are determined. Interest rates are a vital tool to all the macro-economic policy objectives of a government such as control of inflation, investment as well as employment. Interest rates refer to the price paid by deficit agents for borrowing funds from the surplus agents. A line that plots interest rate at a set point in time is the term structure or yield curve. Interest rates which may be short term or long term are linked to a…show more content…
This particular curve is unusual as it is inverted. The market is anticipating a fall in rates and hence the shape of the yield curves. The sensitivity of such a curve can be explained taking into account that the change in the rates reflected is small, 0.24% over the duration of the security, 30 years. This is quite relevant when speculating on future economic conditions. (www.bankofengland.co.uk) There are three main theories which relate to yield curves. The pure expectations theory implies that forward rates are unbiased estimators of future interest rates. This theory states that the term structure of interest rates reflects the views of the market about the path of future short term interest rates. Thus when explaining a positive yield curve, the market will be expecting short term interest rates to rise in the future. The opposite applies when the curve is negative and when flat the markets expect short term interest rates to remain approximately the same. This theory generally over -estimate interest rates and does not assume that investors are risk averse and want a higher return when investing. The liquidity preference theory states that bond holders are risk averse and wish to be compensated for holding the long term security by a liquidity premium. The normal yield curve to explain this should be up sloping indicating preference for liquidity by investors and lower risk of shorter term
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