The term structure of interest rates, spot rates, and yield to maturity in the main body of this chapter, we have assumed that the interest rate is constant over all future periods. The theories that attempt to explain the term structure of interest rates are. The drawing of a bending moment diagram for a beam is an act of structural analysis which requires a knowledge of structural theory in. The goal of this reading is to explain the term structure and interest rate dynamicsthat is, the process by which the yields and prices of bonds evolve over time. In this model, anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices. Instead, businesses should continually assess their organizations. This study takes the position that the traditional expectational approach is, in principle, correct and of substantial importance in understanding the actual behavior of market interest rates of securities with different terms to maturity. Cir considers the problem of determining term structure as being a problem in general equilibrium theory. Particular theories are developed to explain the nature of bond yields over time. Theories of the term structure of interest rates finance essay. The expectations theory has occupied a prominent place in both theoretical and policy debates at various times. As a result, term structure theory is often described as the theory of the yield curve. Development theory economics and political science.
It combines the main features of both the expectations and segmented market. Any study of the term structure is incomplete without its background theories. Understanding the term structure of interest rates. Below theories of term structure of interest rates helps finance executives to understand expected inflation and interest rates.
If future short rates are expected to remain constant, then the long. Term structure of interest rates theories bbalectures. Pdf a theory of the term structure of interest rates. I believe that this stratified content of the survey will improve the understanding of the readers about the term. The term structure of interest rates the yield curve iv. Structural theorists might argue that these legislative discussions in fact occurred, and. Previous theories of term structure have taken the certainty model as their starting point and have proceeded by examining generalizations of the certainty equilibrium relationships.
It simplifies the return of one bond as a combination of the return of other bonds. The expectations theory of the term structure of interest rates states that the yields on financial assets of different maturities are related primarily by market expectations of future yields. The expectations theory of the term structure and short. Moulines encyclopedia of life support systems eolss anything we need to have previously, as a matter of course, a set of concepts by means of which the claims or propositions are formulated. View notes lecture 7 term structure theories, interest rate risk. We begin our construction of an overall theory of the term structure with a reformulation of the expectations theory. Theory of structures, to analyse a given structure under specified loading and possibly other disturbances such as temperature variation or movement of supports. Ross this paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. Lecture 7 term structure theories, interest rate risk.
If sub sequent research lends credence to this theory, economists may give more emphasis to risk aversion in constructing theories of other aspects of financial. Viceira1 recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Short term equity claims, or dividend strips, have on average significantly higher returns than the aggregate stock. The expectations theory of the term structure holds that the longterm interest rate is a weighted average of present and expected future shortterm interest rates. Among the earlier econ omists who sought to explain the interest rate structure, j. The liquidity premium theory has been advanced to explain the 3 rd characteristic of the term structure of interest rates. Rather, it is an improvement over the other term structure theories and is the most acceptable among the majority of economists. Three theories with different assumptions about ris and return. Trade off theory assumes that firms have one optimal debt ratio and firm trade off the. This relationship has several determinants, such as interest rates and yield curves. Term structure of interest rate definition, theories. If short term rates are high, the yield curve tends to slope down.
Quadratic term structure models conditional correlations of the state variables. Only market expectations for future rates will consistently impact the yield curve shape. The term structure of interest ratesmarket interest rates at various maturitiesis a vital input into the valuation of many financial products. The term structure of the riskreturn tradeoff john y. Three theories are proposed to explain the evolution of spot rate curves. All three variations share a common assumption that short term forward interest rates reflect market expectations of short term rates will be in the future. The term structure of interest rate refers to the relationship between time to maturity and yields for a particular category of bonds at a particular point in time. The term structure of interest rates generally refers to the structure of spot and forward ratesnot the coupon yield curve. G12 abstract we summarize and extend the new literature on the term structure of equity. Although illiquidity is a risk itself, subsumed under the liquidity premium theory are the other risks associated with longterm bonds.
The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. Determinants of term structure of interest rates spot rate years. The contingency theory takes into account the growth of the business rather than focusing on its resources. Pdf a theory of the term structure of interest rates researchgate. Modigliani and miller were two professors who studied capital structure theory. Then the traditional theory will be recast in terms consistent with. The information content of the term structure of interest. To display the term structure of interest rates on securities of a particular type at a particular point in time, economists use a diagram called a yield curve. Interest rates on bonds of differing maturities tend to move together when short term interest rates are low, the yield curve tends to slope up. Appendix 5a the term structure of interest rates, spot. It applies the theory to broad changes in the rate structure since 1920, and examines some of its implications for economic stabilization policies. Alternatively, these two hypotheses can be viewed as complementary explanations of the same phenomenonthe term structure of interest rates. Abstractthis paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates.
Understanding the term structure of interest rates st. They are pertinent in understanding why and how are the yield curves so shaped. Pdf this paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. It is the thesis of this investigation that the term structure of interest rates can be explained better by a combination of the expectations and liquidity preference hypotheses than by either hypothesis alone. Traditional theories of the term structure of interest rates j. It simplifies the return of one bond as a combination of the return of. By and large, previous theories of the term structure have taken the certainty model as their starting point and have proceeded by examining stochastic. A positively shaped curve indicates that rates will increase in the future, a flat curve signals that rates are not expected to. A theory of the term structure of interest rates semantic scholar. The term structure of shortrate expectations behaves in accordance with standard monetary theory. The theory of the term structure of interest rates, although it has not figured in the renowned controversies over the theory of the interest rate, has concerned both students of credit control and active participants in debt markets. Bonds, bond prices, interest rates, and the risk and term. Expectations theory states that current longterm rates can be used to predict short term rates of future.
Unesco eolss sample chapters history and philosophy of science and technology vol. Many of the factors traditionally mentioned as influencing the term structure are thus included in a way. In this model, anticipations, risk aversion, investment. I will use the word to describe any arbitragefree model in which bond yields are af. The use of the term development to refer to national economic growth emerged in the united states beginning in the 1940s and in association with a key american foreign policy concern. I the nature and structure of scientific theories c. Theories systematize phenomena by exhibiting deductive and inductive inferential relations among their descriptive terms. Theories of the term structure of interest rates finance. Financial economics term structure expectations theory the expectations theory says that the long term interest rate is the average of the current and expected future short term rates. It assumes that once a business is experiencing growth in assets, capital and resources, remaining in a static or unchanging organizational structure is unproductive. A theory of the term structure of interest rates article pdf available in econometrica 532. A positively shaped curve indicates that rates will increase in the future, a flat curve signals that rates are not expected to change, and an inverted yield curve points to interest rates falling in the future. The expectations theory of the term structure the expectations theory of the term structure holds that the long term interest rate is a weighted average of present and expected future short term interest rates.
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