Scribd
Upload
87 views3 pages

New Microsoft Word Document

This document discusses yield curves and interest rate theories. It explains that a normal yield curve is upward sloping, with longer-term interest rates higher than shorter-term rates. It then outlines three main theories for the shape of the yield curve: 1) pure expectation theory, which is based on expectations of future interest rates, 2) liquidity premium theory, where higher rates on longer-term bonds compensate investors for tying up their money, and 3) market segmentation theory, where interest rates depend on supply and demand within different term segments. The document also discusses why sometimes yield curves can be downward sloping, such as when short-term rates are pushed up by high demand.

Uploaded by

mai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
87 views3 pages

New Microsoft Word Document

This document discusses yield curves and interest rate theories. It explains that a normal yield curve is upward sloping, with longer-term interest rates higher than shorter-term rates. It then outlines three main theories for the shape of the yield curve: 1) pure expectation theory, which is based on expectations of future interest rates, 2) liquidity premium theory, where higher rates on longer-term bonds compensate investors for tying up their money, and 3) market segmentation theory, where interest rates depend on supply and demand within different term segments. The document also discusses why sometimes yield curves can be downward sloping, such as when short-term rates are pushed up by high demand.

Uploaded by

mai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 3

Yield Curves and Interest Rate

Structure - ACCA FM Technical


Article

In ACCA FM (Financial Management, or ACCA F9) exam, 1 of challenging


areas is risk management.

Risk management is divided into foreign exchange rate and interest rate risk
management.

In this concise technical article, I share with you the causes of interest rate
fluctuations theories, including -
1. Term structure of interest rates or yield curves;
2. Pure expectation theory;
3. Liquidity premium theory; and
4. Market segmentation theory.
In addition, example is extracted from ACCA F9 past exam paper to explain
how the theories can be applied to come up a correct answer.

The following discussion about yield curves and related theories is in Question
& Answer format which is considered more easy for you to follow.

Yield Curve Theories

1. What is yield curve?


Answer: Yield curve refers to the relationship between the interest rates
(redemption yield) and the terms to maturity, it is also known as Term
Structure of Interest Rates.

2. What is a normal yield curve look liked?


Answer: A normal yield curve is usually upward sloping, i.e., the longer the
terms to maturity, the higher is the yield.
3. Is there any theory explaining yield curve?
Answer: Yes. There are 3 theories behind yield curve, namely, Pure
Expectation Theory, Liquidity Premium Theory and Market Segmentation
Theory.

Other Theories Explaining Interest Rate Fluctuations

4. What is Pure Expectation Theory? And how it relates to yield curve?


Answer: This theory based solely on investors' expectation on future interest
rates. If investors expect that interest rates will rise (fall) in the future, yield
curve will be upward (downward) sloping.

5. What is Liquidity Premium Theory? How does it relate to yield curve?


Answer: Investors must be compensated for tying up their money for a longer
period of time, thus a higher rate of interest must be paid on longer maturity
bonds.

6. What is Market Segmentation Theory? How does it relate to yield curve?


Answer: This theory suggests that interest rates depended entirely on the
demand and supply at a particular segment (terms to maturity) of the market.

Downward Sloping Yield Curves

7. Why is yield curve sometimes downward sloping?


Answer: In general, liquidity premium theory prevails and dominates the
shape of yield curve.It means longer maturity will have higher yield to
depositors in order to compensate for tying up their money.

However, when there is a strong party requires higher yield for short term
funds and it pushes up short term rate to even higher than long term rate.

The yield curve is an average reflecting the financial market, and “kinks” will
exist where one type of investor becomes more significant than another.

Conclusion
Yield curve theories are explaining the causes of interest rate fluctuations
while we have -
1. Term structure of interest rate or yield curves;
2. Pure expectation theory;
3. Liquidity premium theory; and
4. Market segmentation theory.

You might also like