If liquidity is tight, rates will go up, and if it’s loose, rates would go down or stay flat. The following theories examine a yield curve for a 10-year government bond in the UK, US, and China. Liquidity preference theory deals with long-term bonds (10 years) because of the government's time and money, making it riskier. This is also an indicator of the soundness of an economy. 3- The Market Segmentation Theory. comment on the yield curve (shape, theories,etc) and discuss its importance of making financial decisions. Yield curves are generally plotted view the full answer. A. Theories explaining the evolution of the Yield Curve. Recall that yield curves (also known as the term structure of interest rates) plot debt maturities (the independent variable) against interest rates (the dependent variable). The longer investors are willing to borrow long term, the lower the chances of having those rates go up and lower the demand for borrowing at a higher rate in the short term. This theory explains the predominance of the normal yield curve shape. For example, Let’s take US Treasury that offers bond with a maturity of 30 years. These are part of the yield curve moves. Bonds issued by similar issuers would start yielding, say 12%. The Fed meant to send an aggressive signal to the markets. If all the tenors’ yields do not move by the same amount, then the shift in the curve is called a ‘non-parallel shift.’. This is the fourth post in our series on fixed-income securities. According to this theory, yields tend to change over time, but the theory fails to define the details of yield curve shapes. II) Local Expectation Theory: This theory is derived from Unbiased Expectation Theory and takes on the approach that investors are risk-neutral. The following table illustrates a yield curve. Term structure reflects the markets current expectation of the future rates. This price fall and price rise due to changes in interest rates (depending on the initial position taken whether you’ve bought or sold the bond short) is known as ‘price risk or interest rate risk.’. This theory also states that if the additional returns to be gained are large enough then the institutions and the agents will be willing to deviate from their preferred habitats. IV. The higher return would be the effect of the liquidity premium.IV) Market Segmented Theory: This theory argues that the yield curves are not a reflection of expected spot rates or liquidity premium but rather a function of supply and demand for funds of a particular maturity. If the curve is flat or inverted, it could indicate that the economy may be closed or is in a recession to one. According to this theory, as the name suggests there is no bias between the forward expected rate curve and the future realised spot curve. The yield curve – also called the term structure of interest rates – shows the yield on bonds over different terms to maturity. Upward sloping yield curve is consistent with the market expecting higher or lower spot rates in the future. The investor may not hold a bond until maturity and faces price risk if yields go up to where he would have to sell the bond cheaper before maturity. and suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. Setting: 1. Every security is risk-free and yield is the risk-free rate of return for that particular security. For example: Investors are indifferent between buying a bond that has a maturity of 5 years and holding it for 3 years vs buying a series of 3 one year bonds. – The assignment should include 2000 words. Secondly, it assumes that investors are indifferent to investing in bonds of different maturities since it looks like the risk is the same. V) Preferred habitat theory: This theory takes on the side of segmented market theory as well as expectations theory and is more closely aligned with the real-world phenomena to explain the term structure of interest rates. It is subjective and doesn’t really matter much unless we totally screw it up – you can’t call a T-Bill is a T-Bond even by mistake. Setting the Context: Understanding and being able to predict how the Yield Curve is going to evolve over time, would enable investors to make better informed decisions for their capital allocations. Three theories to explain the general shape of the yield curve: 1- The expectations theory (also known as Unbiased Expectations Theory). The same is applicable to bonds since they are essentially loans – term premium. Next, holding the bond for a long period may not be feasible since the bond may not be liquid – it might not be easy to sell the bond in the first place if yields go down to the benefit of the bondholder! The offset value is given as a subscript, e.g., R p0.2 =310 MPa. b. Yield curve The plot of yield on bonds of the same credit quality and liquidity against maturity is called a yield curve. 2- The liquidity Performance Theory. – The assignment should include 2000 words. How Does a Yield Curve Work? While twists and parallel shifts generally talk about straight moves, a butterfly is about the curvature. An upward slope yield curve implies that short-term rates would continue rising, a flat curve implies that rates could either stay flat or rise, and a downward slope curve implies that rates would continue falling. A butterfly is a humped shape curve. Bank of Japan January 11, 2017 Masayoshi Amamiya Executive Director of the Bank of Japan (English translation based on the Japanese original) 1 Introduction . In general, the short term rates are influenced the most by Central Bank policy rate changes, and long term rates are influenced the most by expected inflation. 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