In this lesson, you will learn the definition of the term structure of interest rates and its related concepts. The behavior of this fundamental benchmark of interest rate is followed by all the economic agents in the setting of the macro economy.
What is a common thread going through the whole macroeconomic system, linking all the separate players such as the government, businesses, and consumers? It is the interest rate. It acts as a signal in moving funds among these players. This is true in the international arena, too, through foreign exchange rates. In a perfect market, the interest rates over different maturity should be the same given the same risk since these interest rates are affected by the risk only. In reality, however, this is not true.
In economics, the relationship between different terms or maturities (for instance, 1 month, 1 year, or 10 years), and the interest rates for risk-free debt is called the Term Structure of Interest Rates. In real life, the term structure of interest rate is rarely horizontal over the time. As you can see, the benchmark interest rates either rise or decline as the maturity of debt increases. In other words, the flat yield curve (b) is a theoretical behavior of the interest rate in the perfect capital market and this rarely happens.
Now, we need to come up with some explanations to account for the difference between the theoretical flat term structure and real (either increasing or decreasing) term structures.
In general terms, the following observations of interest rates over time are made in reality.
1. Interest rates for different terms move together.
2. Interest rates on short-term debts fluctuate more than those on long-term debts.
3. The term structure of interest rates usually slopes upward in most cases.
To account for these facts, we will introduce three existing theories of the Term Structure of Interest Rates: Expectations Theory, Segmented Market Theory, and Liquidity Premium Theory.
The underlying premise of this theory is that investors are indifferent to the maturity of bonds. So, they can switch bonds if their interest rates are not competitive with other maturities. In economics, these bonds are called perfect substitutes. According to this theory, therefore, all the long-term rates are simply the averages of expected future short-term rates.
Segmented Markets Theory
The underlying assumption of this theory is that markets for different maturity bonds have their own set of supply and demand, thus completely insulated from each other. The interest rate for each bond with a different maturity is determined by their own supply and demand set of the segmented market.
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Throughout our discussion of the term structure of interest rate theories, we have assumed that average investors are risk averse and demand a premium for longer maturity bonds because of inflation and interest rate risk. The longer the term of the bond, the greater the bond market price changes due to a given change in interest rates. The buyer of long-term bonds, therefore, require higher premiums for the higher risks (inflation & interest rate risks) of long-term bonds.
Interest rates are the only common thread linking all the different players in the macro economy. The relationship between different terms and the interest rates for risk-free debt is called the Term Structure of Interest Rates. The behavior of this fundamental benchmark of interest rates is very carefully followed by all the economic agents to use the rate as their basis for decision making and to predict what is in store in the future in terms of economic activity. The term structure and the direction of interest rates are also often used to judge the overall credit market condition.
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