Term Structure of Interest Rates For an investment of $1

it = today's interest rate on a one-period bond

Bonds with identical risk, liquidity, and tax
ite1 = interest rate on a one-period bond expected for next period
characteristics may have different interest rates
because the time remaining to maturity is different i2t = today's interest rate on the two-period bond

 Yield curve: a plot of the yield on bonds with

differing terms to maturity but the same risk, Expected return over the two periods from investing $1 in the
liquidity and tax considerations two-period bond and holding it for the two periods
 Upward-sloping: long-term rates are above (1 + i2t )(1 + i2t )  1

short-term rates  1  2i2t  (i2t ) 2  1

 2i2t  (i2t ) 2
 Flat: short- and long-term rates are the
Since (i2t ) 2 is very small
same
the expected return for holding the two-period bond for two periods is
 Inverted: long-term rates are below short- 2i2t
term rates
If two one-period bonds are bought with the $1 investment
Facts Theory of the Term Structure of Interest Rates (1  it )(1  ite1 )  1
Must Explain 1  it  ite1  it (ite1 )  1
it  ite1  it (ite1 )
1. Interest rates on bonds of different maturities
it (ite1 ) is extremely small
move together over time
Simplifying we get
2. When short-term interest rates are low, yield it  ite1
curves are more likely to have an upward slope; Both bonds will be held only if the expected returns are equal
when short-term rates are high, yield curves are 2i2t  it  ite1
more likely to slope downward and be inverted it  ite1
i2t 
2
3. Yield curves almost always slope upward The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
Three Theories to Explain the Three Facts
it  ite1  ite 2  ...  ite ( n 1)
int 
1. Expectations theory explains the first two facts n
The n-period interest rate equals the average of the one-period
but not the third interest rates expected to occur over the n-period life of the bond

2. Segmented markets theory explains fact three

 Explains why the term structure of interest rates
but not the first two
changes at different times
3. Liquidity premium theory combines the two  Explains why interest rates on bonds with different
theories to explain all three facts maturities move together over time (fact 1)
 Explains why yield curves tend to slope up when
Expectations Theory
short-term rates are low and slope down when
 The interest rate on a long-term bond will equal short-term rates are high (fact 2)
an average of the short-term interest rates that  Cannot explain why yield curves usually slope
people expect to occur over the life of the long- upward (fact 3)
term bond
Segmented Markets Theory
 Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold  Bonds of different maturities are not substitutes
any quantity of a bond if its expected return at all
is less than that of another bond with a  The interest rate for each bond with a different
different maturity maturity is determined by the demand for and
 Bond holders consider bonds with different supply of that bond
maturities to be perfect substitutes
Liquidity Premium &
Example Preferred Habitat Theories

Let the current rate on one-year bond be 9%.  The interest rate on a long-term bond will equal
You expect the interest rate on a one-year bond an average of short-term interest rates
to be 11% next year. expected to occur over the life of the long-term
Then the expected return for buying two one- bond plus a liquidity premium that responds to
year bonds averages (9% + 11%)/2 = 10%. supply and demand conditions for that bond
The interest rate on a two-year bond must be
9% for you to be willing to purchase it.
 it  it1
e
 it2
e
 ... it(
e

int   lnt n1)

n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

Liquidity Premium and Preferred Habitat Theories

 Interest rates on different maturity bonds move

together over time; explained by the first term
in the equation
 Yield curves tend to slope upward when short-
term rates are low and to be inverted when
short-term rates are high; explained by the
liquidity premium term in the first case and by a
low expected average in the second case
 Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens

FIGURE 6 Yield Curves and the Market’s Expectations

of Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory

FIGURE 7: Yield Curves for U.S. Government Bonds