The term structure of interest rate describes the relationship between interest rates and the term to maturity and the differences between short term and long term interest rates.
The relationship between short and long interest rates is important to corporate managers because:
- They must decide whether to buy long term or short term bonds and whether to borrow by issuing long-term or short-term bonds.
- It enables them to understand how long term and short term rates are related and what causes the shift in their relative positions.
Several theories had been advanced to explain the nature of yield curve – These are:
- Liquidity preference theory
- Expectation theory
- Market segmentation theory
1. Liquidity Preference Theory
This theory states that short term bonds are more favourable than long term bonds for 2 reasons.
- Investors generally prefer short term bonds to long-term securities because such securities are more liquid in the sense that they can be converted to cash with little danger of loss of principal.
Therefore – investors will accept lower yields on short term securities.
- At the same time borrowers react in exactly the opposite way.
Generally borrowers prefer long term debt because short-term debt exposes them to the risk of having to repay the debt under adverse. Conditions, accordingly borrowers are willing to pay higher rate other things held constant for long-term process than short ones.
Taking together this two sets of preferences implies that under normal conditions, a positive maturity risk premium exist which increases with maturity thus the yield curve should be upward sloping. Lenders prefer liquidity (short term hands) while borrowers prefer long term bonds and are willing to pay a “premium” for long term borrowing.
2. Expectation Theory
This theory states that the yield curve depends on the expectation about future inflation rates. If inflation rate is expected to increase, then the rate on long-term bonds will exceed that of short-term loan. The expected future interest rates are equal to forward rates computed from the expectations with regard to future interest rates are. Other factors which affect the expectations with regard to future interest rates are:
- Political stability
- Monetary policy of the government
- Fiscal policy of the government (government expedition)
- Other economic related factors including social factors.
The following conditions are necessary for the expectation theory to hold.
- Perfect capital markets exists where there are many buyers and sellers of security with non having a significant influence on the interest rates.
- Investors have homogeneous expectations about future interest rates and returns on all investments.
- Investors are rational wealth maximizers
- Bankruptcy of firms due to use of borrowing is unlikely.
3. Market Segmentation Theory
This theory states that the major investors (borrowers and lenders) are confined to a particular segment of the market and will not change even if the forecast of the likely future interest rates changes.
The lenders and borrower thus have a preferred maturity e.g a person borrowing to buy a house or a company borrowing to build a power plant would want a long term loan. However a retailer borrowing to build up stock in readiness for a peak reason would prefer a short term loan. Similar differences exist among
savers e.g a person saving to pay school fees for next semester would want to lend on in the short-term market. A person saving for retirement 20 years ahead would probably buy long-term security in L.T market.
The thrust of market segmentation theory is that the slope of yield curve depends on demand and supply mechanism. An upward sloping curve would occur if there was a large supply of funds relative to demand in the short term marketing but a relative shortage of funds in the long-term market would produce an upward sloping curve.
Tests of the 3 theories
Various test have been conducted mainly in USA and they indicate that all the 3 theories have some validity and thus the shape of the yield curve of any firm is affected by the following:
- Supply and demand conditions in the short and long term market.
- Liquidity preferences of lenders and borrowers
- Expectation of future inflation. While any of the 3 factors may dominate the market all the 3 effect the term structure of interest rate.