Explain the term structure of interest rates. What are the effects of rise in risk and expectations on the formation of long term rates?
Interest rate within an economy is subject to many factors and as a result varies in relativity of those. The major factors are time period: short term Vs. long term investments, the degree of risk to which its exposed (AAA rated, mortgages, default, zero coupon…).
Term structure of Interest rate is a significant tool for investors of bonds but also for policy makers, in terms of having an overview of whether to invest in short or longer term securities. This essay will go on to explain the term structure of interest rate how it is used by investors, ...view middle of the document...
This curves represents normal market conditions where investors behaviours indicate their beliefs of no changes in the economy e.g. stability of inflation rates etc. this is where investors are drawn to invest in long term bonds assuming their yield will be higher due to future market looking stable. This links to the known factor which is: the higher the risk the higher the return meaning that holding long term therefore more risky investments generates higher returns as the maturity prolongs the liquidity premium increases (as well as the maturity/risk premium).
However an upward slope is not always the case we notice that the upward slope is not steep and is not reflective of the market in all cases which brings us to the flat yield curve showing numerous movements within the markets. Uncertainty about the future then becomes stronger which encourages risk aversion meaning short term interest rate will rise as a result. This last result can lead to an inverted yield curve even though this is a rare condition which would most likely occur when future interest rate is known to drop which lead to investors opting for short term assets giving higher yield than those in the long term as the price of the bond is known to drop in the future.
Such a measure implements a projection of future performances since future spot interest rates are unknown the yield curve serves as a benchmark or an approximation of expected returns on these types of securities thus appeases the uncertainties dreaded by most investors.
The degree of risk will also affect investor’s decisions. Since the information about future of Interest rate is incomplete and it is known that the further into the future we try to forecast the more wrong we are, long term bonds hence present a greater risk. The term premium theories assume that most investors are risk averse and as we know interest rate is known increase as the maturity increases a premium on the return is generated. This addition to interest rate is needed to persuade risk adverse investors and savers to lend more long term securities.
The expectation theory suggests that observing the term structure is indeed a tool for market participants to forecast the future and therefore a cause of the different expectations. This theory represents an important tool as it has a major influence over the relationship between yield and the term to maturity of bonds. It shows how future changes affect the current structure if the yield curve shows stability it means that borrowers and lenders are at equilibrium of current patterns of IR in other word they are both lending and borrowing as much as each other .
The theory looks into future rates:
If long term is for 2years it will be demonstrated as:
Where iL= long term interest rate
As short term loans are of 1 year lenders might want to renew at the expected rate of 1 year by comparing it with the earning on the investment at...