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    This document discusses yield curves and interest rate theories. It explains that a normal yield curve is upward sloping, with longer-term interest rates higher than shorter-term rates. It then outlines three main theories for the shape of the yield curve: 1) pure expectation theory, which is based on expectations of future interest rates, 2) liquidity premium theory, where higher rates on longer-term bonds compensate investors for tying up their money, and 3) market segmentation theory, where interest rates depend on supply and demand within different term segments. The document also discusses why sometimes yield curves can be downward sloping, such as when short-term rates are pushed up by high demand.

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    This document discusses yield curves and interest rate theories. It explains that a normal yield curve is upward sloping, with longer-term interest rates higher than shorter-term rates. It then outlines three main theories for the shape of the yield curve: 1) pure expectation theory, which is based on expectations of future interest rates, 2) liquidity premium theory, where higher rates on longer-term bonds compensate investors for tying up their money, and 3) market segmentation theory, where interest rates depend on supply and demand within different term segments. The document also discusses why sometimes yield curves can be downward sloping, such as when short-term rates are pushed up by high demand.

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    42 views3 pages

    New Microsoft Word Document

    Uploaded by

    mai
    This document discusses yield curves and interest rate theories. It explains that a normal yield curve is upward sloping, with longer-term interest rates higher than shorter-term rates. It then outlines three main theories for the shape of the yield curve: 1) pure expectation theory, which is based on expectations of future interest rates, 2) liquidity premium theory, where higher rates on longer-term bonds compensate investors for tying up their money, and 3) market segmentation theory, where interest rates depend on supply and demand within different term segments. The document also discusses why sometimes yield curves can be downward sloping, such as when short-term rates are pushed up by high demand.

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    of 3

    Yield Curves and Interest Rate

    Structure - ACCA FM Technical


    Article

    In ACCA FM (Financial Management, or ACCA F9) exam, 1 of challenging


    areas is risk management.

    Risk management is divided into foreign exchange rate and interest rate risk
    management.

    In this concise technical article, I share with you the causes of interest rate
    fluctuations theories, including -
    1. Term structure of interest rates or yield curves;
    2. Pure expectation theory;
    3. Liquidity premium theory; and
    4. Market segmentation theory.
    In addition, example is extracted from ACCA F9 past exam paper to explain
    how the theories can be applied to come up a correct answer.

    The following discussion about yield curves and related theories is in Question
    & Answer format which is considered more easy for you to follow.

    Yield Curve Theories

    1. What is yield curve?


    Answer: Yield curve refers to the relationship between the interest rates
    (redemption yield) and the terms to maturity, it is also known as Term
    Structure of Interest Rates.

    2. What is a normal yield curve look liked?


    Answer: A normal yield curve is usually upward sloping, i.e., the longer the
    terms to maturity, the higher is the yield.
    3. Is there any theory explaining yield curve?
    Answer: Yes. There are 3 theories behind yield curve, namely, Pure
    Expectation Theory, Liquidity Premium Theory and Market Segmentation
    Theory.

    Other Theories Explaining Interest Rate Fluctuations

    4. What is Pure Expectation Theory? And how it relates to yield curve?


    Answer: This theory based solely on investors' expectation on future interest
    rates. If investors expect that interest rates will rise (fall) in the future, yield
    curve will be upward (downward) sloping.

    5. What is Liquidity Premium Theory? How does it relate to yield curve?


    Answer: Investors must be compensated for tying up their money for a longer
    period of time, thus a higher rate of interest must be paid on longer maturity
    bonds.

    6. What is Market Segmentation Theory? How does it relate to yield curve?


    Answer: This theory suggests that interest rates depended entirely on the
    demand and supply at a particular segment (terms to maturity) of the market.

    Downward Sloping Yield Curves

    7. Why is yield curve sometimes downward sloping?


    Answer: In general, liquidity premium theory prevails and dominates the
    shape of yield curve.It means longer maturity will have higher yield to
    depositors in order to compensate for tying up their money.

    However, when there is a strong party requires higher yield for short term
    funds and it pushes up short term rate to even higher than long term rate.

    The yield curve is an average reflecting the financial market, and “kinks” will
    exist where one type of investor becomes more significant than another.

    Conclusion
    Yield curve theories are explaining the causes of interest rate fluctuations
    while we have -
    1. Term structure of interest rate or yield curves;
    2. Pure expectation theory;
    3. Liquidity premium theory; and
    4. Market segmentation theory.

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