Relationship of Interest Rates, Term to Maturity, and Marketability Financial Instruments - Coursework Example

Financial Instrument: Yield Curve Student’s Name Institutional Affiliation Relationship of Interest Rates, Term to Maturity, and Marketability Financial Instruments The shape of the yield curve is determined by a different economic factor that includes the rate of interest, the expected inflation rate, and the interest rate risk. The business cycle depends on the variation of the real rate of interest. The highest rates are observed, especially at the end of the business expansion period, whereas the during the business recession, it is the lowest real rate of interest. The shape of yield curve experiences some slope changes with the changes of the expected future real rate of interest. The other economic factor influencing the shape of the yield curve is the expected inflation rate. The financial instrument investors use the economic variables to determine the expected rate of inflation (Thomas, 2006). If the projection of investors indicates that inflation would increase in future, then the yield curve shape becomes upward sloping. This is due to long-term interest rates that include the larger inflation premium comparing to short-term interest rates. In addition, if the inflation subsidy is expected in the future, then the investors would consider investing more and hence leading the yield curve to be downward sloping (Chinn & Kucko, 2015). Finally, the interest rate risk is greater when the maturity of security is longer and hence leading to higher interest rate. This is indicated by an upward slope of the yield curve as a result of the interest risk premium. Marketability is the ability of the investor selling their financial instruments quickly at a fair market value and a lower transaction cost. Higher marketability of the securities is achieved when their costs are low. In a competitive financial market, the relationship of marketability and securities are varied inversely to interest rate and yields (Gogas, Papadimitriou, & Chrysanthidou, 2015). The marketability risk premium is the yield given by interest rate obtained from the difference of marketable security and marketable financial instrument or security. In reality, United States Treasury Bills are the securities that have the largest and most attractive secondary market. The term structure of the rate of interest is developed by the relationship of yield and term of maturity of securities. The variation of the term to maturity of the interest rate is indicated by the changes in the yield curves (Saar & Yagil, 2015). This ensures that changes to the interest rates are constant over a period and hence defining the yield curve. The yield curve tends to take different slopes up and down slopes depending on the general level of the rate of interest over time. Yield curve takes different shapes with respect to the marketability, the rate of interest and the inflation expectation (Claggett, 2016). The upward sloping or normal yield curves happen in the growing economy, whereas flat yield curve occurs when the rate of interest is stable and unlikely to change soon. An inverted yield curve that is also known as the descending curve is downward sloping and occur when the business cycle is approaching to a recession or the decline of the economy. Theories Explaining the Yield Curve Shape The graphical representation of the yield curve is determined plotting the yield versus security maturity. This results into ascending, flat and even twisted curves depending on the outcome of the security market, demand and business cycle. The three main theories explaining the shape of yield curve include expectation, liquidity premium, and market segmentation theory. The Expectation Theory The argument for expectation theory is based on the development of the yield curve based on the future interest rate expected changes and movement. The investors use the expectation theory to reflect on the future trend of the market (Chinn & Kucko, 2015). The shape yield curve is then determined by the changes and movement in the rate of interest projection. Moreover, the investors’ projection is under the presumption of the efficient market trade that has accurate and reliable information as well as minimal trading or transaction costs. Under the expectation theory, the slope of the yield curve gives information to investors on the future interest rates. The ascending yield curves occur when the interest rate is expected to increase with the maturity of securities. The positive responding yield curves are also known as the normal yield curve. The reflection of the ascending yield curve will tend to indicate increasing interest rates in the future (Gogas, Papadimitriou, & Chrysanthidou, 2015). The descending yield curve shows the short term rates are usually higher compared to the long term rates. The shapes of the descending yield curves are inverted and hence indicating investors expect a lower rate of interests in future. The last shape of the yield curves is flat curves whereby it implies that the expected interest rates are going to be stable in the near future. The shapes of the yield curve help the financial instruments investors to understand the market trend and expectation of the interest rates. Through the analysis of the market, it is essential for the investors to relate the market information to the project of the appropriate mechanism to follow in order to have a profitable trade in securities (Saar & Yagil, 2015). The long term approach to the interest rates provides more information using a geometric average of both current and expected future rates of interests. These geometric averages aspects are also referred to as implied and forward interest rates. The forwards rates are the interest rates that are expected in the future are based on the calculation through observing two different spots of differing interest rate maturity. Liquidity Premium Theory The theory indicates that long term securities tend to have greater variability in price and less marketability compared to the short-term financial instruments. In investing on the less liquid securities, the investors are supposed to have premium. The liquidity is a critical factor for investors to consider during securities, investment as premiums tend to keep on changing depending on the business cycle. The increase in the security liquidity premium with the maturity, the market yield curve tends to become upward sloping compared to the yield curve predicted using the expectation theory (Claggett, 2016). This indicates that the liquidity premium theory is more accurate as it can explain the reason why the yield curve slopes upward in the security market most of the time compared to the prediction by expectation theory approach. Therefore, the securities investors concentrate on the yield curve in respect to the upward sloping mechanism to relate the market returns. Market Segmentation Theory The maturity preferences tend to influence the security prices and providing an explanation of different variations in the yields over a period. Investors and borrowers of securities tend to select the security with the maturity that reflects their satisfaction of forecasted cash. In addition, the yield curve is projected by the demand and supply for the securities in the stock market depending on the maturity point (Thomas, 2006). Predetermination of both short-term and long-term maturities is formulated by the need and not the expectation of the interest rates in future. Furthermore, the institutions offering pension funds and life coverage insurance tend to prefer the long-term investment that is aligned to their long-term liabilities (Huxley, Burns, & Fletcher, 2016). The institutions such as commercial banks focus on the short-term investments to cater for their short-term liabilities. Therefore, the investors issue securities depending on the maturity to match their financial needs. The market segment theory and preferred habit theory provide the investor with the chance to shift to their preferred maturities depending on the yields. The variation of the market segment and preferred habit theory are based on the willingness of investor in shifting from the preferred maturity to premium based on the needs of expectation of Securities yields (Saar & Yagil, 2015). In addition, the market segment theory provides an explanation of twists, spikes and also the discontinuation of the yield curve. The preferred habit theory also indicates the reason for yield curve tends to be smooth without discontinuity. Yield Curve and Business Cycle The economic activities are directly related to the interest rates level. The ascending yield curve forecast m higher expectations in the security market and hence economic expansion. On the other hand, the descending yield curve indicates low interest rates that reflect to lower inflation rates or even the economic growth is slow. Furthermore, the security market tends to respond to the information arising in the market, the expectation as well as a reflection of the reactions experienced in the price and yields of securities. In brief, the yield curve relates to the business cycle and hence reflecting the economic growth. The changes of the interest rate, maturity term, and marketability aspects influence the yield curve. Investors in stock exchange focus on the business cycle to ascertain their expectation in the securities. Both long-term and short-term securities depend with the investors’ projection with the market. Furthermore, institutions offering pension fund and life insurance invest into the long-term securities compared to a commercial bank that considers short-term securities. Therefore, the yield curve expresses the economic growth dynamics and hence guiding the investors in security trade. References Chinn, M., & Kucko, K. (2015). The Predictive Power of the Yield Curve Across Countries and Time. International Finance. Vol. 18 Issue 2, 129-156. Claggett, T. (2016). A TUTORIAL ON BONDS, YIELD CURVES AND DURATION. Journal of Business & Behavioral Sciences. Vol. 28 Issue 1, 49-61. Gogas, P., Papadimitriou, T., & Chrysanthidou, E. (2015). Yield Curve Point Triplets in Recession Forecasting. international Finance. Vol. 18 Issue 2, 207-226. Huxley, S., Burns, B., & Fletcher, J. (2016). Equity Yield Curves, Time Segmentation, and Portfolio Optimization Strategies. Journal of Financial Planning. Vol. 29 Issue 11, 54-61. Saar, D., & Yagil, Y. (2015). Corporate yield curves as predictors of future economic and financial indicators. Applied Economics. Vol. 47 Issue 19, 1997-2011. Thomas, L. B. (2006). Money, banking, and financial markets. Mason (OH): South-Western, cop. Read More