Question

Explain the Expectation Theory of the term structure of interest rates

Answer #1

The expectations theory explains the relationship between short-
and long- term interest rates**.** As per the theory,
the long term rates are entirely governed by the expected future
path of short-term interest rates. This theory predicts what will
be the short-term interest rates in the future based on current
long-term interest rates The long-term rates are used to indicate
at which rates of short-term bonds will trade in the future.

It also suggests that the interest earned by an investor by investing in one two-year bond today, will be equal to the interest earned by investing in two consecutive one-year bond investments. Thus, the expectations theory is also known as the "unbiased expectations theory." It helps the investors to make decisions by forecasting the future interest rates.

Considering the expectation theory and the term structure of
interest rate, why is it that, in general, the cost of
borrowing/interest rates for businesses tend to be low when the
economy is doing very well.

Using the Expectations Theory of the term structure,
calculate the interest rates in the term structure for maturities
of 1 to 5 years for the following paths of one year interest rates
over the next five years. Explain for each what the yield curve
would look like.
3% 4% 5% 6% 7%
3% 2% 1% 1% 2%

Describe the “pure expectations theory” of the term structure of
interest rates

1-According to the expectations theory of the term structure of
interest rates,
A
a long-term interest rate is equal to the average of current and
expected future short-term interest rates.
B-
the yield curve is always flat.
C-
a short-term interest rate has no relation to long-term interest
rates.
D- a short-term interest rate is equal to the average of current
and expected future long-term interest rates.
2-The expectations theory of yield curves is not very realistic
because
A-
a...

The _ theory purposes the term structure of interest
rates is determined solely by the demand for and supply of
securities hacking a specific maturity

According to the liquidity premium theory of the term structure
of interest rates, if the one-year bond rate is expected to be
3%, 6%, and 9% over each of the next three years, and if the
liquidity premium on a three-year bond is 3%, then the interest
rate on a three-year bond is _?

a. (2 pts.) What is the fact number two that the term structure
of interest rates explains?
b. (6 pts.) Explain this fact using the liquidity premium
theory.

Explain what the term structure of interest rates is and draw a
graph that depicts it under normal circumstances.

Explain the market segmentation theory of the term
structure.

1. Explain how the Term Structure of Interest Rates (Yield
Curve) can serve as a signalling tool in the financial system. Give
clear examples of its use in forecasting future inflation rates,
interest rates and economic activity.

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