The relationship between short term interest rate and long term interest rate is called term structure of interest rate. It is the interest structure between the interest rates having same risk but different maturity time. Several theories have been proposed to explain the shape of the yield curve.
The three major ones are:
- Expectation theory
- Liquidity Preference theory and
- Market Segmentation Theory
Expectation theory states that the shape of yield curve depends on the investors expectation about future inflation rates. This theory proposes that long term interest rates can act as a predictor of future short term interest rates. Most investors care about future interest rates especially the bond investors. For the bondholders, the future short term interest rate acts as determing factor for the price of the bond. If the interest rate increases, the price of the bond will decrease and vice-versa.Hence, if it is expected to increase the future short term interest it is better to avoid long-term maturity bonds.
2.Liquidity Preference theory:
Liquidity Preference theory states that interest rate always depends on the investor’s preference of bond with different maturity. In other word, if investor prefer more liquidity that will cause to increase the market interest rate and if investor prefer less liquidity that will cause to decrease the market interest rate.
3.Market Segmentation Theory:
Market Segmentation Theory states that interest rate depends on the demand and supply of short-term and long-term bond in different market segments(money market and capital market). In other words,this theory states that each lender and each borrower has a preferred maturity ,and assumes that investment is to minimize risk. The way to minimize risk is to match the maturities of securities with holding periods .Borrowers prefer to buy long-term assets from a long-term loan and short-term loan for short-term purposes.
Copyright : Shankar Mishra
Source : Finance I (KEC Publication )