Question

Proficient-level: Define the concept, term structure of interest rates. List and describe the three theories explaining the shape of the term structure of interest rates. Distinguished-level: Identify the slope of the most common yield curve for a U.S. Treasury security.

Answer 1

The term structure of interest rates is the relationship between bond prices or bond yield at different maturities. When the term structure is graphed it is called the yield curve.

Theories shaping the tern structure of interest rates:

• Pure expectation theory :the expectations about the future interest rates, will determine the shape of the yield curve.
• Liquidity preference  theory :Investors prefer the short term bonds to long term bonds as there is uncertainty associated with the long term bonds. Investors demand a liquidity premium for holding the long term bonds.
• Preferred habitat theory :This theory rests on the assumption that investors will match the assets and liabilities.

For a US treasury security, the most common shape of the yield curve is upward sloping, which determines that the investors expect the short term interest rates to rise in the future.