STUDENT NAME EDWIN NCUBE

STUDENT NO P0112514L

PROGRAMME RISK MANAGEMENT AND INSURANCE

DEPARTMENT ACTUARIAL AND RISK MANAGEMENT

COURSE INVESTMENT AND PORTFOLIO MANAGEMENT

LECTUER MR T ZINYORO

QUESTION
Discuss the Theories of the term structure of interest rates
Term Structure of Interest Rates

Elton (2011, p 236 ) defined the term structure of interest rates as the variation of the yield of bonds
with similar risk profiles with the terms of those bonds. The yield curve is the relationship of the
yield to maturity (YTM) of bonds to the time to maturity, or more accurately, to duration, which is
sometimes referred to as the effective maturity. In most cases, bonds with longer maturities have
higher yields. However, sometimes the yield curve becomes inverted, with short-term notes and
bonds having higher yields than long-term bonds. Sometimes, the yield curve may even be flat,
where the yield is the same regardless of the maturity. The actual shape of the yield curve depends
on economic conditions, fiscal policies, expected forward rates, inflation, foreign exchange rates,
foreign capital inflows and outflows, credit ratings of the bonds, tax policies, and the current state
of the economy. The term structure of interest rates has 3 characteristics:

The change in yields of different term bonds tends to move in the same direction.
The yields on short-term bonds are more volatile than long-term bonds.
The yields on long-term bonds tend to be higher than short-term bonds.

In order to explain the term structure of interest rates there are four well‐known theories that can be
considered. These are; (i) Expectations theory, (ii) Market segmentation theory, (iii) Liquidity
theory, and (iv) Preferred Habitat theory each. The expectations hypothesis has been advanced to
explain the 1st 2 characteristics and the premium liquidity theory have been advanced to explain the
last characteristic. The market segmentation theory explains the yield curve in terms of supply and
demand within the individual segments. The market segmentation theory can explain only the third
fact. Since each of the two theories explains facts that the other cannot, we have to combine the
two to get another theory that can explain all three empirical facts. This will lead us to the liquidity
premium theory which is a combination of the features of the other two. Finally, the preferred
habitat theory is closely related to the liquidity theory.

Market Segmentation Theory

Because bonds and other debt instruments have set maturities, buyers and sellers of debt usually
have preferred maturities. Bond buyers want maturities that will coincide with their liabilities or
when they want the money, while bond issuers want maturities that will coincide with expected
income streams. Market Segmentation Theory (MST) posits that the yield curve is determined by
supply and demand for debt instruments of different maturities. Generally, the debt market is
divided into 3 major categories in regard to maturities: short-term, intermediate-term, and long-
term. The difference in the supply and demand in each market segment causes the difference in
bond prices, and therefore, yields. There are many different factors that would cause differences in
the supply and demand for bonds of a certain maturity, but much of that difference will depend on
current interest rates and expected future interest rates Wood (1964). If current interest rates are
high, then future rates will be expected to decline, thus increasing the demand for long-term bonds
by investors who want to lock in high rates while decreasing the supply, since bond issuers do not
want to be locked into high rates. Therefore, long-term interest rates will be lower than short-term
rates. On the other hand, if current interest rates are low, then bond buyers will tend to avoid long-
term bonds so that they are not locked into low rates, especially since bond prices will decline when
interest rates rise, which will generally happen if interest rates are already low. On the other hand,
borrowers generally want to lock in low rates, so the supply for long-term bonds will increase.
Hence, a lower demand and a higher supply will cause long-term bond prices to fall, thereby
increasing their yield.

Preferred Habitat Theory

Preferred Habitat Theory (PHT) is an extension of the market segmentation theory, in that it posits
that lenders and borrowers will seek different maturities other than their preferred or usual
maturities (their usual habitat) if the yield differential is favourable enough to them. For instance, if
short-term rates are a lot lower than long-term rates, then bond issuers will issue more short-term
bonds to take advantage of the lower rates even though they would prefer longer maturities to match
their expected income streams; likewise, lenders will tend to buy long-term debt if the yield
advantage is significant, even though carrying long-term debt has increased risks.

This theory is also an offshoot of the liquidity premium theory which means that investors take into
consideration both expected returns and maturity. However, they have a preference on which bond
they would like to invest according to that particular bond’s maturity. In order for investors to
invest in bonds which do not have the desirable maturity they would require a higher expected
return on those bonds. Specifically, investors can trade outside their preferred maturity if they
receive a risk premium for investing in bonds with non‐preferable maturity. A notable fact is that
market participants usually prefer short‐term bonds to long‐term bonds and they would never
choose a long‐term bond that gives them the same interest rate with a short‐term bond.
Expectations Hypothesis

This theory states that the interest rate on a long‐term bond will equal an average of the short‐term
interest rates that people expect to occur over the life of the long‐term bond (Mishkin and Eakins,
2012, p.138). For example the yield on a two‐year bond is set so that the return on that bond is the
same as the return on a one‐year bond. If the interest rate for the 1st year is 4% and the expected
interest rate, which is often referred to as the forward rate, for the 2nd year is 6%, then one can be
either buy a 1-year bond that yields 4%, then buy another bond yielding 6% after the 1st one
matures for an average interest rate of 5% over the 2 years, or one can buy a 2-year bond yielding
5%—both options are equivalent: (4%+6%) / 2 = 5%. Hence, the sequential 1-year bonds are
equivalent to the 2-year bond. (Actually, the geometric mean gives a slightly more accurate result,
but the average is simpler to calculate and the argument is the same.)

Note that this relationship must hold in general, for if the sequential 1-year bonds yielded more or
less than the equivalent long-term bond, then bond buyers would buy either one or the other, and
there would be no market for the lesser yielding alternative. For instance, suppose the 2-year bond
paid only 4.5% with the expected interest rates remaining the same. In the 1st year, the buyer of the
2-year bond would make more money than the 1st year bond, but he would lose more money in the
2nd year—earning only 4.5% in the 2nd year instead of 6% that he could have earned if he didn’t
tie up his money in the 2-year bond. Additionally, the price of the 2-year bond would decline in the
secondary market, since bond prices move opposite to interest rates, so selling the bond before
maturity would only decrease the bond's return.

Note, however, that expected future interest rates are just that – expected. There is no reason to
believe that they will be the actual rates, especially for extended forecasts, but, nonetheless, the
expected rates still influence present rates.

According to the expectations hypothesis, if future interest rates are expected to rise, then the yield
curve slopes upward, with longer term bonds paying higher yields. 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 of
interest rates:

The yield of bonds of different terms tend to move together.

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

Friedman and frank (1990, p 289) stated that a key assumption in understanding the expectations
theory is that investors who set the prices do not care about risk (are risk neutral). They care about
the instrument that offers the highest expected return, no matter what their time horizon is. Bonds
with this characteristic are considered to be perfect substitutes. What we mean by that is that if
bonds with different maturities are perfect substitutes, the expected return on these bonds must be
equal. To get deeper into this assumption we consider two investment strategies:

1. Purchase a one‐year bond, and when it matures in one year, purchase another one‐year bond.
2. Purchase a two‐year bond and hold it until it matures.

Since both strategies must carry the same expected return in order for investors to be indifferent in
holding a one‐year or two‐year bonds, the interest rate on the two‐year bond must equal the average
of the two one‐year interest rates.

However, in the Quarterly Journal of Economics (August 1964), pp. 457-70 it stated that 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

In order to find a theory which can explain all three facts, we combine the previous two theories and
create a new one which is called the Liquidity premium theory. This new theory states that the
interest rate on a long‐term bond will equal an average of short‐term interest rates expected to occur
over the life of the long‐term bond plus a liquidity premium (Mishkin and Eakins, 2012, p.143). It
is a fact that all kind of bonds can be risky since there is uncertainty about inflation and future
interest rates.

Liquidity is defined in terms of its marketability) New York: McGraw‐ Hill, (2009, p 156‐163), 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. Assets may be illiquid because they are riskier and/or because supply exceeds
demand. Additionally, illiquid assets are more difficult to price, since previous sale prices may be
stale or non-existent.

What bondholders look into is the purchasing power of the return – the real return – they receive
from bonds not just how much they will get from the coupon payments. If there is uncertainty
about the level of inflation then there will be uncertainty about a bond’s real return, making the
investment a risky one. The longer the maturity of a bond, the higher is the uncertainty since the
harder is to estimate the level of inflation. The interest rate risk arises from a mismatch between an
investor’s investment horizon and a bond’s time to maturity. If an investor decides not to hold a
bond until it matures but sell it beforehand then any changes in the interest rate (which ultimately
will cause the bond’s price to change) generates capital gains or losses.

The liquidity premium theory has been advanced to explain the 3rd characteristic of the term
structure of interest rates: that bonds with longer maturities tend to have higher yields. Although
illiquidity is a risk itself, subsumed under the liquidity premium theory are the other risks associated
with long-term bonds: notably interest rate risk and inflation risk. Naturally, 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.

Besides liquidity, there are 2 other risks with holding bonds that increases with the term of the bond:
inflation risk and interest rate risk Cecchetti, G. S. (2008 . 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. 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 bondholder for the greater risk.

The three main patterns created by the term structure of interest rates are the following:

1) Normal Yield Curve; This yield curve shape is formed during normal market conditions,
where no significant changes in the economy are expected to take place such as in inflation rates,
and also the economy will continue to grow at a normal rate. During these conditions, the market
expects long‐term fixed‐income securities to offer higher yields than short‐term fixed‐income
securities. This is considered to be a normal expectation since short‐term instruments bear less risk
than long‐term instruments; the farther into the future a bond matures, the more uncertainty the
bondholder faces before being paid back the principal. To invest in one instrument for a long period
of time an investor must be compensated for undertaking the additional risk. Therefore this normal
yield curve is thought to reflect the higher inflation‐risk premium that investors demand for long‐
term bonds. In general if current interest rates increase, the price of a bond will decrease and its
yield will increase.

2) Flat Yield Curve: This yield curve shape generally implies that the short‐term rates will equal
the long‐term rates. In such conditions it is difficult for the market to determine whether interest
rates will move in either direction in the future. A flat yield curve usually occurs when the market is
making a transition that shows different but simultaneous indications of what interest rates will do.
What we mean is that there may be some signals that short‐term rates will raise and other signals
that long‐term rates will fall. This condition will create a curve that is flatter than its normal
positive slope. When the yield curve is flat, investors can maximize their risk‐ return trade‐off by
choosing fixed‐income securities with the least risk, or highest credit quality.

3) Inverted Yield Curve: These yield curves are rare, and they form during unusual market
conditions where the expectations of the investors are completely the opposite of those
demonstrated by the normal yield curve. Under this contradictory situation, investors expect bonds
with longer maturity to offer lower yields than bonds with shorter maturities. This inverted yield
curves indicates that the market currently expects interest rates to decline in the future which
consequently means that the market expects yields of long‐term bonds to decline. As interest rates
decrease, bond prices increase and yields decline. The concept of risk premium states that investors
would demand a compensation for taking on more risk when investing in long‐term instruments.
But in the case of an inverted yield curve, why would investors choose to purchase long‐term fixed‐
income investments when they expect to receive less compensation for taking on more risk? The
answer is that some investors interpret this inverted yield curve as an indication that the economy
will soon experience a slowdown, which causes future interest rates to give even lower yields.
Hence they want to lock their money into long‐term instruments before the yields are driven even
more down.
A drawback of the basic yield curve is that it does not take into consideration securities that have
varying coupon rates. Therefore it is necessary to develop a more accurate estimate of the Treasury
yield curve. By the following approach we will be able to identify yields that apply to zero‐coupon
bonds and therefore eliminate the problem of coupon rate differences in the yield‐maturity
relationship.

Which one of these theories is the best?

If we want a theory that adjusts with the daily changes in the term structure then we would prefer
the Preferred Habitat Theory. But if we want to look into long‐run decisions then the expectations
and liquidity theory will be more applicable.
Interpreting Yield Curves:

• If the yield curve slopes slightly upwards, interest rates are expected to stay the same in the future.
• If the yield curve slopes sharply upwards, short‐term rates are expected to rise.
• If the yield curve is flat, short‐term interest rates are expected to fall only slightly.
• If the yield curve slopes downwards, short‐term interest rates are expected to decline sharply.

In conclusion, in this study I started from the basics explaining interest rates, yield curves and then
went on to the term structure and the four main theories that reflect the different shapes of the term
structure. I have looked into the different theories separately and examined their functions and
stating the facts each one satisfies. Therefore, our main conclusion is that interest rates in general
and the term structure can provide useful information to market participants and help them to
forecast events in the economy in order to adjust their policies.
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