# Theories Of The Term Structure Of Interest Rates Finance Essay

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This coursework explains what information does 'term structure of interest rate' gives to finance executives while analyzing project. Term Structure of interest rate is important in formulating investment decisions. Term structure of interest rate compares the market yield (Saunders & Cornett, 2003, p. 190). The shape of the yield curve reflects the market's future expectation of the interest rate. Thus, the term structure is important for a finance executive, because they believe that interest rate across time tells about the market's expectation of future events (John Cox et al, 1985). Also, the behaviour of term structure impacts monetary policy (Marvin, 1998), economic activity (Dotsey, 1998) and inflation. By having understanding the term structure will help them to extricate information and predict how variables such as interest rates, maturity will affect the yield curve. Thus, helps them to take investment decision in order to generate future capital gain and cash flow.

This coursework will first discuss about interest rate, yield in context of term structure of interest rate. Next section critically assesses the four different theories of term structure and what information do these theories have. In conclusion, importance of interest rate to finance executive is portrayed and validity of which theory holds good in today's market is discussed.

## Interest rates, Yield curves and Term Structure of Interest rates

The main component of term structure is prices, Interest rates and time (term). Interest rates are important to understand because all the financial instruments are sensitive to interest rates. Financial executive invest in the projects depending on alternative options and cost of capital which depends on interest rates. One of the major concerns in making investment decision is uncertainty about the future capital/ rewards from the investment. Finance executives have to take decision in the unstable economic environment where the information comes gradually, so knowing term structure interest rate helps them to decide

whether to invest and when to invest (Dias & Shacklenton, 2005). Interest rate change with time due to risk, inflation, and also depends on variables such as tax, term of maturity. Term Structure of interest rate i.e. Yield curve is analysis tool of different interest rates of bonds or securities with different term of maturity (Marvin, 1998).

## Why to understand yield curves?

The yield to maturity is quantified as the rate of return that mathematically equates the fixed payment stream to the bond's current market price. The yield to maturity cannot be easily calculated, so it must be analysed through trial and error method. Yield to maturity is same as internal rate of return (McInish, 2000). Finance executives are concerned with the internal rate of return the project will generate. Term structure is relation between different yields. This section first explains about yields and their importance and then assesses theories of term structure of interest rates.

There are three yield curves: upward sloping, downward sloping and flat. If the yield curve is upward sloping it means that long term rates are above short term rates.

As depicted in the figure, it has positive slope means that finance executive expects the economy to grow in future (Mishkin, 1990). As economy will grow it will lead to increase in inflation rates. With the rise in the inflation rate, central bank with tighten the monetary policy to control the inflation rate (Marvin, 1998). This generates the risk for uncertainty in inflation rate and to future value of cash flows.

If the yield curve is downward sloping it means that long term rates are below short term rates (Mishkin, 2006).It means that finance executive expects interest rates and economy to fall. Tight monetary policy could lead long term rates to be lower than short term rates.

If the yield curve is flat means that long term rates are equal to short term rates.

Term structure of interest rate is defined as relation between interest rate and yield curve for default free securities having different maturity (John Cox et al, 1985). Term structure of interest rate is the correlation between different yields of financial instruments with same risk, tax but different maturity (Saunders & Cornett, 2003). The term-structure model mainly analyses the expectations channels and the interest rate. While taking decision, the IRR (Internal rate of return) of the projects needs comparison with the opportunity cost of capital. But often the long run and short run interest rate/opportunity costs differs. And both cash flow and cost of capital include the inflation. Below theories of term structure of interest rates helps finance executives to understand expected inflation and interest rates.

## Theories of term structure of interest rates

There are four theories namely expectation theory, market segment theory, liquidity preference theory and preferred habitat theory that explains the shape of yield curve (Saunders & Cornett, 2003, p. 190).

## Expectation Theory

John Hicks's (1939) expectation theory suggests that expectation, of the investors in the market, about the future interest rate determine the term structure of interest rates and these expectations could affect the economic growth (Russell, 1992). This theory assumes that bonds with different maturities are perfect substitutes. Buyers will not prefer bond for which expected return is less than the expected return of another bond. Inflation and interest rate risk are not considered in this theory (Mishkin, 2006). According to this theory, expected return of the long term rates are average of short term rates. It means there is no uncertainty in expected rate of return over the holding period as return is same for all the securities over the holding period (Mishkin, 2006).

Expectation theory proves that two facts, first, "Interest rate for different maturities move together over the time" and second "Yields on short-term bond more volatile than yields on long-term bonds" (Mishkin, 2006). Yield curve is based on market expectation.

If the finance executives expect that the short term rates will be 10% in next 3 years, then interest rate on 3-year bond will also be 10%. For finance executive opportunity will be less because the yield curve will be flat as current long term rate is equal to current short term rate. This imply that movement of short term rates and long term rates can be predicted and if the yield curve is sloping upward then future interest rate will increase and if curve is sloping downwards then future interest rate will decrease (Russell, 1992). If the short term rates are high, yield curve will be downward sloping. Yield curve will be expected to be upward sloping if short term rates are low [1] . Hence this theory doesn't prove why the yield curve is usually upward sloping (Mishkin, 2006).

As per this theory, finance executives are assumed to be investing in efficient market and with less transaction cost. Thus, Yield curve is determined by the short term interest rates and by uncertainty in the accuracy of their expectation.

## Liquid preference theory

As the expectancy theory doesn't completely explain the term structure i.e. current rates are not perfect predictor of future interest rates (Saunders & Cornett, 2003), this theory is an extension of the expectancy theory i.e. it gives some importance to the expected future rates but give more importance to the risk preference of the finance executives or investors (Mishkin, 2006). If the market is uncertain then finance executive will make decision based on capital gain/loss, revenue generated (Kessel, 1965). This decision will be based on their willingness to take risk. Risk [2] causes the interest rates to be greater than the expected rates and this amount increases with the maturity. Long term interest rate includes the expected

rates and premium for holding long term rates bond. This premium is known as liquidity premium (Mishkin, 2006), which is compensation to the finance executives or investors for holding long term securities.

The theory assumes that bonds are substitutes but not perfect substitutes .Short term rates are of lower inflation and low interest rate risks (Mishkin, 2006). Investor prefers short term rates (Keynesian view) and hence be given premium for long term rates. Long rates will be less volatile as it is the average of the short term rates and risk premium will increase with the maturity, thus, yield curve will be upward sloping (Kessel, 1965). With the increase in the maturity, sensitivity to capital loss increases with decreasing rate (Saunders & Cornett, 2003). Investor prefers short term rates as it is less prone to capital loss. It doesn't mean that they are risk averse; they may be unwilling to take the risk due to economic activity. As mentioned above, risk premium will increase with the term of maturity, upward sloping yield curve may reflect the expectation of investor that future short term rates will rise and therefore, the yield curve will also increase with the term to maturity (Saunders & Cornett, 2003).

## Segmented market theory

This Theory assumes that credit markets are segmented (Shelile, 2006). Investor has preference for specific maturity bonds and hence the market for these bonds are separated based on their maturity. This means that longer interest rate securities are completely different asset when compared to short term interest rate securities (Mishkin, 2006).

As per this theory, Investors decide which term securities they want to hold. They don't prefer to change the market segment to take the advantage of the changing yields in other segment (Saunders & Cornett, 2003). Investor preference depends on the asset and liability they hold. For example bank prefers short term interest rate due to their deposit liabilities and insurance company prefers long term interest rate due to their contractual liabilities. Thus, Demand and supply for particular securities, with in particular segment, determine the interest rates (Howells and Bain, 1998).

This theory explains the fact 3 - why the yield curves are usually upward sloping and assumes that Investor prefers liquid portfolio. Thus they prefer short term securities. Bonds/securities with shorter period have low risk and lower inflation, means yield will be lower and yield on long term bond will be higher (Shelile, 2006). This proves the fact that yield curve is usually upward sloping. However, as the market for the bond is segmented, it fails to prove why the yields of different term move together (Mishkin, 2006).

## Preferred habitat theory

Moldigliani and Sutch (1966) recognised the limitation of market segment theory and gave preferred habitat theory, which is a combination of both expected theory and market segment theory. According to Mishkin, preferred habitat theory is closely related to liquidity premium theory.

Preferred habitat investors invest in their preferred maturities and do not invest in across market segment. Movement in yield of different maturity has no effect in demand by preferred habitat (Doh, 2010).

Finance executives will invest in outside of preferred maturity if they are compensated by higher expected return or term premium (Howells and Bain, 1998). Finance executives consider both expected return and maturity. However, understanding of determinant of term premium is difficult (John Cox et al, 1985). Below chart shows that there is close relationship between the risk premium and the yield curve. If risk premium is positive then yield curve tend to be upward sloping and vice versa. This proves that investor/ finance executives expect interest rate to rise when yield curve is upward sloping and require positive risk premium to compensate for future capital losses (Christopher Peacock, 2004)

Source: Christopher Peacock, 2004, Bank of England: Deriving a market-based measure of interest rate expectations

## Why to have understanding of different theories

Term structure inform about the expectation of other investors in the market.

Expectation of other market investor will influence the current decision and these decisions will determine what will happen in the future. Thus knowledge of other market investor is helpful in determining the future forecast (Russell, 1992)

Theories explain that changes in short term rates will affect long term rates.

Short term rates have direct effect on long term interest rates and finance executive are concerned majorly with the long term interest rates as it help them to make the decisions about investments (Russell, 1992)

Monetary policy has direct effect on short term rates.

Fama (1990) and Mishkin (1990) study shows that term spread gives information about the future macroeconomic variables such as inflation. To control the inflation central bank tightens the monetary policy and tightening leads to rise in short term interest rates.

These theories predict about the economic activity and to know about the economic activity is important as this will help in forecasting, budgeting and meeting the future demand (Dotsey, 1998). Investor/ financial executives are forward looking and thus yield spread between short term and long term interest rate predicts the future economic activity (Watson, 1989). However, 1990-91 economic downturn was not predicted by these theories. But later studies by Estrella and Mishkin (1997, 1998) determined that spread contain the significant amount of information about the future economic activity. Their conclusion was supported by Dueker (1997) and Plosser and Rouwenhorst (1994) studies.

## CONCLUSION

## Which Theory is most appropriate?

The Liquidity Preference hypothesis, the Preferred Habitat hypothesis, and the Market Segmentation hypothesis all depend on an analysis of investor and firm preferences under certainty to conclude about the term structure premium under uncertainty.

Liquidity Preference hypothesis suggests that it is the nature of risk aversion which mostly causes the forward rate to be far greater than the expected future rate. This view has been criticized for overtly emphasising on capital-value risk as opposed to income risk. Someone who wants future flow of income could simply make a long term investment and stay unconcerned about variations in interest rate, also for them, a yield premium might be necessary to induce them to hold shorter term structure. Preferred habitat theory advocates that due to variation in individual's notion of saving and investment, different investor would be view the investment risk differently.

Preferred Habitat Theory is the most consistent theory to analyse daily changes in the term structure. However, in the long run, expectations of future interest rates and liquidity premiums are vital elements of the shape and position of the yield curve.

## Why should finances executive have understanding of term structure of interest rate?

While analyzing project proposals, the finance executives obviously expect stable cash flow or income generation for company's economic viability. As discussed above, the term structure of interest rate predicts the economic condition. So, instead of erratic cash flows of increasing flow in one cycle and decreasing in another, they expect stable value for their money. Hence, future growth can be forecasted by the term structure of the interest rates.

While borrowing money for investments, both assets and liabilities are at interest rate risk. If liabilities have greater risk than assets, then there is a risk that an increase in interest rate might result in financial ruin. Financial executives can alter the risk by their choice of duration of portfolios. Risk aversion, investment alternatives, anticipations and preferences about the timing of investment all have a vital role in determining the term structure. Therefore, Finance executives should have good understanding of term structure.

## REFERENCES

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Christopher Peacock, 2004. "Deriving a market-based measure of interest rate expectations". Bank of England Quarterly Bulletin: Summer 2004. P. 142- 152

Dias, J. c., & Shacklenton, M. B. (2005). Investment hysteresis under stochastic interest rates.

Dotsey, Michael (1998). "The Predictive Content of the Interest Rate Term Spread for Future Economic Growth," Federal Reserve Bank of Richmond Economic Quarterly.

Fama, E.F. (1990): "Term-structure forecasts of interest rates, inflation and real returns". Journal of Monetary Economics, 25 (1), January, P. 59-76.

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Kessel, R. A. (1965). WHY LIQUIDITY PREFERENCE EXISTS. In The Cyclical Behavior of the Term Structure of Interest (pp. 44 - 58). National Bureau of Economic Research.

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Mishkin, F. (2006). Money, Banking, and Financial. Pearson.

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