I’m gonna explain to you, the term structure of interest rates.
What is the interest rate? First, what is the interest rate? The interest rate or required return represents the price of money. This is the compensation that a demander of funds must pay to a supplier. Interest rates act as a regulating device that controls the flow of money between suppliers and
demanders of funds. When the demand for funds increases, the interest rate tends to rise. Conversely, when the supply of funds increases, the interest rate tends to fall.
When funds are lent, the cost of borrowing is the interest rate.
When funds are raised by issuing stocks or bonds, the cost the company must pay
is called the required return, which reflects the suppliers expected return.
The Central Bank regularly assesses economic conditions. When necessary,
it initiates actions to change interest rates to control inflation and economic growth.
The Fisher Effect
Next, let’s talk about the Fisher Effect, or Fisher Hypothesis.
The Fisher Effect defines the relationship
between nominal interest rates, real interest rates, and inflation rate.
The nominal interest rate, or quoted rate, equals to real interest rate plus expected
inflation rate plus real interest rate, times expected inflation rate.
By approximation, nominal rate = real rate + expected inflation rate.
Specifically, the real interest rate is the rate that creates an equilibrium between the
supply of savings and the demand for investment funds in a perfect world. In this context, a perfect world is one in which there is no inflation,
where suppliers and demanders have no liquidity preference, and where all outcomes are certain.
The Fisher Effect: Example
Let’s take an example. If you require a 10% real return,
and expect inflation to be 8%, what is the nominal rate?
By using the formula, you will get 18.8%.
Or by approximation, the answer is around 18%.
Term Structure of Interest Rates and Yield Curves
Next, let’s look at the term structure of interest rate and the yield curves.
Term structure of interest rates is the relationship between the remaining time
to maturity and the yield to maturity of a bond. Time to maturity is the length of
holding period of the bond, while the yield to maturity is the expected return on a bond.
Whereas the yield curve is a graph that represents the relationship between the
remaining time to maturity and the yield to maturity of a bond at a given point in time.
Types of Yield Curve
There are two types of yield curve.
First type, upward-sloping yield curve or normal yield curve,
that’s when the long-term interest rate is higher than the short-term interest rate.
Second type, downward-sloping yield curve or inverted yield curve,
that’s when the long-term interest rate is lower than the short-term interest rate.
Theories of Term Structure of Interest Rate
There are three theories used to explain the term structure of interest rate.
Expectations Theory, Market Segmentation Theory, and Liquidity Preference Theory.
Expectations Theory
The first, Expectations Theory.
This theory suggests that the shape of the yield curve is based upon investors’ expectations of the future direction of inflation and interest rates. If there is an expectation of higher future inflation,
investors will ask for higher interest rates on the long-term bond to compensate for risk. So, you will get an upward-sloping yield curve.
However, if there is an expectation of lower future inflation, investors will only need
lower interest rates on the long-term bond. So, you will get a downward-sloping yield curve.
In general, the strong relationship between inflation and interest rates supports this theory.
Market Segmentation Theory
The second, Market Segmentation Theory.
This theory suggests that the shape of yield curve is based upon the supply and demand
for funds, and the markets for different maturity bonds are completely segmented.
If the demand is more than the supply for short-term funds, it means more people are looking
for money in the short-term. So, short-term interest rate will become higher. In other words,
long-term interest will become lower. Therefore, you will get a downward sloping yield curve.
But, if the demand is less than the supply for short-term fund, it means, more people are
supplying money in the short-term. So, short-term interest rate will become lower. In other words,
long-term interest will become higher. Therefore, you will get an upward sloping yield curve.
Liquidity Preference Theory
The third, Liquidity Preference Theory.
This theory contends that, long term interest rates tend to be higher than short term rates,
in which you will get an upward-sloping yield curve.
The reason is because investors perceive long-term bonds to be riskier than short-term bonds. If investors’ money is tied up for longer periods
