Chapter 12: Problem 459

How can you explain the interest-term-structure, i.e., the relationship between short-term and long-term interest rates ?

Short Answer

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The interest-term-structure, or the relationship between short-term and long-term interest rates, is visually represented by a yield curve demonstrating the term structure of interest rates. Short-term interest rates apply to borrowings for less than a year, while long-term interest rates apply to instruments with a maturity of more than one year. Three theories help explain this relationship: the Expectations Theory (long-term rates are an average of expected future short-term rates), the Liquidity Premium Theory (long-term rates include a term premium for holding long-term bonds), and the Market Segmentation Theory (interest rates for different terms are determined independently by supply and demand). These theories contribute to the overall understanding of the interest term structure.

Step by step solution

Understand Short-Term and Long-Term Interest Rates

Short-term interest rates are the rates at which short-term borrowings are effected, usually for a period of less than a year. Long-term interest rates, on the other hand, apply to financial instruments with a maturity of more than one year.

The Concept of Interest Rate Term Structure

The term structure of interest rates, also known as the yield curve, represents the relationship between interest rates and the time to maturity of a debt for a given borrower in a given currency. For example, the U.S. Treasury yield curve represents the yields of U.S. Treasury securities all rescheduled to the same year for comparison.

The Expectations Theory

This theory asserts that long-term interest rates are an average of expected future short-term rates. If investors expect future interest rates to be lower than the current short-term rate, a downward sloping yield curve would be observed. Conversely, if interest rates are expected to rise, an upward sloping yield curve would be observed.

The Liquidity Premium Theory

According to the Liquidity Premium Theory (also known as the term premium theory), long-term interest rates not only reflect investors' expectations of future interest rates but also include a premium for holding long-term bonds, known as a term premium. This theory explains why yield curves are typically upward sloping: lenders need to be compensated for the additional risk – such as interest rate uncertainty – that comes with lending for longer periods.

The Market Segmentation Theory

This theory suggests that financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term investments determine their respective interest rates independently. An investor’s preference for a certain maturity determines the slope of the yield curve. For instance, a predominant preference for short-term investments would result in a steeper yield curve. These theories offer different views and predictions about how short-term and long-term interest rates relate to each other, and they collectively give a comprehensive understanding of the interest term structure.