The information content of the term structure of interest. Structural theorists might argue that these legislative discussions in fact occurred, and. Particular theories are developed to explain the nature of bond yields over time. Term structure of interest rate definition, theories. Development theory, cluster of research and theories on economic and political development the emergence of development theory. 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. 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 term structure of shortrate expectations behaves in accordance with standard monetary theory. The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. 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. It simplifies the return of one bond as a combination of the return of. Pdf a theory of the term structure of interest rates researchgate. Among the earlier econ omists who sought to explain the interest rate structure, j. Ross this paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates.
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. Lecture 7 term structure theories, interest rate risk. 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. In this model, anticipations, risk aversion, investment. A theory of the term structure of interest rates article pdf available in econometrica 532.
By and large, previous theories of the term structure have taken the certainty model as their starting point and have proceeded by examining stochastic. 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. G12 abstract we summarize and extend the new literature on the term structure of equity. Modigliani and miller were two professors who studied capital structure theory. The contingency theory takes into account the growth of the business rather than focusing on its resources. Term structure of interest rates is a calculation of the relationship between the yields on defaultfree securities which only differ in their term to maturity. Short term equity claims, or dividend strips, have on average significantly higher returns than the aggregate stock. They are pertinent in understanding why and how are the yield curves so shaped. Understanding the term structure of interest rates st. 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.
Rather, it is an improvement over the other term structure theories and is the most acceptable among the majority of economists. The liquidity premium theory has been advanced to explain the 3 rd characteristic of the term structure of interest rates. Determinants of term structure of interest rates spot rate years. In this model, anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices. The term structure of interest ratesmarket interest rates at various maturitiesis a vital input into the valuation of many financial products. It assumes that once a business is experiencing growth in assets, capital and resources, remaining in a static or unchanging organizational structure is unproductive. Pdf this paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. Only market expectations for future rates will consistently impact the yield curve shape. 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.
Theories systematize phenomena by exhibiting deductive and inductive inferential relations among their descriptive terms. We begin our construction of an overall theory of the term structure with a reformulation of the expectations theory. Below theories of term structure of interest rates helps finance executives to understand expected inflation and interest rates. The term structure of interest rates the yield curve iv. The expectations theory of the term structure and short. Appendix 5a the term structure of interest rates, spot. 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. Term structure of interest rates theories bbalectures.
Theory of structures, to analyse a given structure under specified loading and possibly other disturbances such as temperature variation or movement of supports. 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. I believe that this stratified content of the survey will improve the understanding of the readers about the term. View notes lecture 7 term structure theories, interest rate risk. Understanding the term structure of interest rates. Although illiquidity is a risk itself, subsumed under the liquidity premium theory are the other risks associated with longterm bonds. 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. 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.
Pdf a theory of the term structure of interest rates, econometrica. Unesco eolss sample chapters history and philosophy of science and technology vol. Cir considers the problem of determining term structure as being a problem in general equilibrium theory. Three theories are proposed to explain the evolution of spot rate curves. Pdf a theory of the term structure of interest rates. 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. Expectations theory states that current longterm rates can be used to predict short term rates of future. Any study of the term structure is incomplete without its background theories. Then the traditional theory will be recast in terms consistent with. Three theories with different assumptions about ris and return. In terms of the previous example, where it was calculated that the forward.
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. 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. If future short rates are expected to remain constant, then the long. Traditional theories of the term structure of interest rates j.
It applies the theory to broad changes in the rate structure since 1920, and examines some of its implications for economic stabilization policies. I will use the word to describe any arbitragefree model in which bond yields are af. 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. Many of the factors traditionally mentioned as influencing the term structure are thus included in a way.
The expectations theory has occupied a prominent place in both theoretical and policy debates at various times. Theories of the term structure of interest rates finance. 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. This relationship has several determinants, such as interest rates and yield curves. When graphed, the term structure of interest rates is known as a yield curve, and it plays a central role in an economy. Trade off theory assumes that firms have one optimal debt ratio and firm trade off the. Alternatively, these two hypotheses can be viewed as complementary explanations of the same phenomenonthe term structure of interest rates. 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. Development theory economics and political science. A theory of the term structure of interest rates semantic scholar. Expectations theory and term structure of interest rates.
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. These deficiencies are addressed in chapter 3 with the introduction of the post keynesian approach to interest rate determination. The term structure of the riskreturn tradeoff john y. Theories of the term structure of interest rates finance essay. Bonds, bond prices, interest rates, and the risk and term. 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. Modigliani and sutch have propounded the preferred habitat theory of the term structure of interest rates. It combines the main features of both the expectations and segmented market. I the nature and structure of scientific theories c. A positively shaped curve indicates that rates will increase in the future, a flat curve signals that rates are not expected to.
Bonds, bond prices, interest rates, and the risk and term structure of interest rates econ 40364. As a result, term structure theory is often described as the theory of the yield curve. Quadratic term structure models conditional correlations of the state variables. The theories that attempt to explain the term structure of interest rates are. Abstractthis paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. It simplifies the return of one bond as a combination of the return of other bonds. If short term rates are high, the yield curve tends to slope down. Instead, businesses should continually assess their organizations.