To explain these facts we shall make use of a three theories of term structure of interest rates. The Expectations Theory, which can explain Facts 1 and 2, cannot. The term structure of interest rates is the variation of the yield of bonds with similar The market segmentation theory explains the yield curve in terms of supply. NBER Program(s):Monetary Economics. Controversies in term-structure theory center around the existence and variability of term premia in securities yields.


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The theory explains the yield curve in terms of expected short-term rates. It is based on term structure theories idea that the two-year yield is equal to a one-year bond today plus the expected return on a one-year bond purchased one year from today.

The Term Structure of Interest Rates: Evidence and Theory

The one weakness of this theory is that it assumes that investors have no preference when it comes to different maturities and the risks associated with them. This theory states that investors want to be compensated for interest rate risk that is associated with long-term issues. It is important that only bonds of similar risk are plotted on the same yield curve.

The most common type of yield curve plots Term structure theories securities because they are considered risk-free and are thus a benchmark for determining the yield on other types of debt.

The term structure theories of the curve changes over time.

Investors who are able to predict term structure theories term structure of interest rates will change can invest accordingly and take advantage of the corresponding changes in bond prices. Term structure of interest rates are calculated and published by The Wall Street Journalthe Federal Reserve, and a variety of other financial institutions.

In general, when the term structure of interest rates curve is positive, this indicates that investors desire a higher rate of return for taking the increased risk of lending their money for a longer time period. However, if future interest rates are expected to decline, then this will cause long term bonds to have lower yields than short-term bonds, resulting in an inverted yield curve.

The inverted yield curve often results when short-term interest rates are higher than historical averages, since there is a greater expectation that rates will decline, so long term bond issuers would be reluctant to issue bonds with higher rates when the expectation is that lower rates will prevail in the near future.

The expectations hypothesis helps to explain 2 of the 3 characteristics of the term structure term structure theories interest rates: The yield of bonds of different terms tend to move together.

Short-term yields are more volatile than long-term yields.

Nested Tests of Alternative Term-Structure Theories

However, the expectations hypothesis does not explain why the yields on long-term bonds are usually higher than short-term bonds. This could only be explained by the expectations hypothesis if the future interest rate was expected to continually rise, which isn't plausible nor has it been observed, except in certain brief periods.

Liquidity Premium Theory The liquidity premium theory has been advanced to explain the 3rd characteristic of the term structure of interest rates: Although illiquidity is a risk itself, subsumed under the liquidity premium theory are the other risks associated with long-term bonds: Term structure theories, increased risks will lower demand for those bonds, thus increasing their yield.

This increase in yield is the risk premium to compensate buyers of long-term bonds for their increased risk. Liquidity is defined in terms of its marketability — the easier it is to sell a bond at its value in the secondary marketplace, the more liquid it will be, thus reducing liquidity risk.

This explains why long-term Treasuries have such low yields, because they are the easiest to sell. Additionally, illiquid assets are more difficult to price, since previous sale prices may be stale or nonexistent. A bond's yield can theoretically be divided into a risk-free yield and the risk premium.

The risk-free yield is simply the yield calculated by the formula for the expectation hypothesis.


The risk premium is the term structure theories premium that increases with the term of the bond. Hence, the yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little, and so the liquidity premium theory term structure theories the term structure of interest rates explains the generally upward sloping yield curve for bonds of different maturities.

Both the inflation rate and the interest rate become more difficult to predict farther into the future. Inflation risk reduces the real return of the bond.

The Term Structure of Interest Rates: Evidence and Theory

Interest rate risk is the risk that bond prices will drop if interest rates rise, since there is an inverse relationship between bond prices and interest rates. Of course, interest rate risk is only a real risk if the bondholder wants to sell before maturity, but it is also an opportunity cost, since the long-term bondholder forfeits the higher interest that could be earned if the bondholder's money was not tied up in the bond.

Therefore, a longer term bond must pay a higher risk premium to compensate the term structure theories for the greater risk.