Theories of Interest Rates


Yeild Curve-   It Shows relationship between Return and Term structure.


THEORIES OF INTEREST RATES:
v  EXPECTATION THEORY-
As per Expectation theory, if we are actually expecting the interest rates to fall they will actually fall leading to a downward sloping yield curve and if we are expecting the interest rates to rise they will increase leading to upward sloping yield curve.
So what might be the driving forces behind these expectations?
·       Political and Global Factors like Government policies (Demonetization, Introduction to GST) or BREXIT.
·       Increase in level expenses i.e. Inflation 

Hence, Yield curve can be upward or downward sloping depends on Expectation

v LIQUIDITY PREFERNCE THEORY-
Long term bonds are less liquid compared to short term bonds , So in order to compensate investors for  the higher liquidity risk involved in long term bonds, this should be awarded with higher returns

So, Long term bonds have higher return compared to short term bonds leading to upward sloping yield curve

v  INFLATION RISK PREMIUM THEORY-
In order to Compensate investors for the Inflation risk in case of Long term bonds , We expect higher  return in long term bonds Compared to short term bonds leading to upward sloping yield curve.

v  MARKET SEGMENTATION THEORY-
The different types of bonds are attracted to different investors. Life insurance and pension funds are generally attracted to long term bonds, General insurance is attracted to Short term Bonds

Suppose, there are a lot of Life insurance and Pensions firm in a country, So demand of long term bonds will be higher than short term bonds leading to higher price of long term bonds as compared to short term bonds, If price of long term bonds is higher than Yield will be lower
So as per this theory, your yield curve can be upward or downward sloping depending on dominant market.

CAUTION :  Real yield curve does not follow Inflation risk premium theory as it already incorporates Inflation.

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