Financial Instruments, Term Structure and Yield Curve - Coursework Example

Financial Instruments, Term Structure and Yield Curve Student’s Name Institution Course Name & Number Date of Submission Financial Instruments, Term Structure and Yield Curve Introduction Interest rates and time to maturity are some of the most important factors that person has to take into consideration when making an investment or borrowing decision. Geiger (2011) attributes this to the fact that the duration it takes for a financial instrument such as a bond to mature determines the amount of interest that the person has to pay at the maturity of the financial instrument. Interest in this case refers to the price of borrowing money for the use of its purchasing power while term to maturity denotes the remaining life of a debt instrument (Choudhry, 2011). That is, the time duration it takes until the last payment of a debt is made. Whenever the interest rates are plotted against the term to maturity, this results in the development of a curve known as yield curve. In other words, a yield curve is a curve portraying the relationship between interest rates of a given security and term to maturity. Using term structure of interest theories, this essay illustrates the relationship between interest rates of different financial instruments and term to maturity in light of their marketability. Yield Curve A yield curve is a very important tool that investors and borrowers can use to make well informed decision about their investment or borrowing decisions. As explained earlier, a yield curve is an expression of the relationship between the cost of borrowing or interest and the time to maturity of a particular financial instrument. Yield curves take different shapes depending on the financial instrument and the relationship between interest rates on that security and time to maturity (Mishkin & Eakins, 2012). The shapes can be normal, steep, flat or inverted yield curves. A normal curve results when the yield of a particular security increases as time to maturity increases (Elton & Gruber, 2009). In other words, the slope of the yield curve is positive in which case an investor expects the economy to perform well in the future and that inflation will also rise in the future rather than fall. A flat yield curve results when long-term yields are below short-term yields (Choudhry, 2011). Flat yield curves usually result in situations where lenders are more interested in long-term debts contracts than short-term debt contracts. An inverted yield curve, however, occurs when interest rates for a given security is lower for each payment period so as to allow lenders to attract long-term borrowing (Elton & Gruber, 2009). Yield Curve Theories The Expectancy Theory The expectation theory is one of the theories used to explain the shape of a yield curve. According to expectation theory, the shape of a yield curve is determined exclusively by the expectation that an investor has about the future movement of interest rate and that the changes in such expectations cause a change in the yield curve’s shape (Geiger, 2011). In this regard, expectation theory is based on the assumption that investors are trading in an efficient market where there is perfect information and little cost. As such, the slope of the yield curve is a reflection of the expectations of an investor regarding the future interest rates. The principal assumption of expectation theory is that investors who set prices of securities are not bothered about risks involved as they are considered risk neutral. The main concern of such investors is investing in instruments that offer the highest expected returns regardless of the duration it takes (Cecchetti, 2008).  This implies that if treasury bonds with different maturities are considered perfect substitutes, then the expected return on such bonds will always be equal. Illustratively, the shape of yield curve can be explained using bonds. Bonds are some of the financial instruments that can help explain the shapes of yield curves. According to the expectation theory, the yield curve assumes an upward slopping shape whenever short interest rates on such bonds are low while the yield curve assumes a downward sloping shape and inverted shape when short-term interest rates are high (Choudhry, 2011). In this regard, the shape of the yield curve assumes an upward slope whenever short-term interest rates are low for a bond because in such a scenario, market participants are expecting that the interests will rise in the future to a normal level in which case the future expected short-term rates will be higher compared to the prevailing short-term rates. For this reason, the yield curve slopes upwards due to the fact that long-term interest rates will rise above the current short-terms rates for the bonds. By contrast, in the event that the short-term rates for the bonds are high, there is an expectation among participants that the rates will fall in the future (Geiger, 2011). This, therefore, causes the yield curve to slop downwards and assumes an inverted shape because market participants have high expectation that long-term interest rates will fall below short-term rates since the average of expected future short-term rates will fall below the prevailing short-term rates. Liquidity Premium Theory Liquidity premium theory explains the shape of a yield curve by maintaining that long-term financial instruments have greater price variability and low marketability compared to short-term financial instruments period (Blake, 2000). As such, investors demand a premium for putting their money in less liquid securities. However, because liquidity may prove an important factor to an investor at some point, liquidity premiums usually adjust over time. The theory is also based on the assumption that because liquidity premium rises with maturity of a security, this causes the market yield curve to assume a more upward sloping than what expectancy theory would predict (Choudhry, 2011). In other words, liquidity theory presumes a more upward sloping yield curve than do expectancy theory. Accordingly, this makes liquidity premium a better theory for explaining why yield curves tend to assume an upward sloping shape most of the time. For example, a person invests in shares, considering that the liquidity premium for shares is normally positive and becomes larger as the term to maturity increases, the yield curve for share equity under the liquidity premium theory will always fall above the yield curve that results from the expectation theory and generally exhibits a steeper slope as shown below. Liquidity Premium Theory Yield Curve Interest Rates Liquidity premium Expectation theory yield curve Years to Maturity, n Market Segmentation Theory of the Term Structure Market segmentation theory holds that borrowers and investors go for securities that have the maturity dates that satisfy their predetermined cash requirements (Geiger, 2011). For this reason, the shape of the yield curve is determined by the demand and supply of securities at or near a given maturity. The theory also maintains that an investor’s choice of long or short-term maturities is pre-determined in accordance with the needs instead of the future expectations of interest rates. Additionally, the theory holds that investors will never move away from their preferred maturities even when given higher yield. The behaviors of the shape of the yield curve under market segmentation theory can be explained using debts as a financial instrument period (Blake, 2000). Naturally, it is known that investors prefer short-term financial instruments to long-term instruments. This is due to the fact that short-term instruments are not only highly liquid, but also less risky. Consequently, this causes the demand for short-term securities to go up, causing high prices and lower yield. Accordingly, this results in a situation where the yield on long-term debts rises above that of short-term debts, thus creating a yield curve that is downward sloping (Cecchetti, 2008).  In this respect, therefore, it can be seen that segmentation theory provides a better explanation as to why yield curves are usually upward slopping and how the spikes, twists and discontinuous yield curves develop. Preferred Habitat Theories of the Term Structure Preferred Habitat Theories states that investors consider both maturity and expected returns when making an investment decision. Nonetheless, investors prefer securities that they would like to invest based on their maturity period (Blake, 2000). In case of shares, for an investor to invest in shares which lack the desired maturity, they would need higher expected returns on such shares. This implies that investors are willing to trade outside their preferred maturity in case they are assured of a high return or risk premium by investing in shares with non-preferable maturity (Cecchetti, 2008).  Therefore, because investors are willing to shift out of their preferred maturity when offered higher yields, the yield curve for shares or bonds under preferred habitat theory take a normal shape or smooth line without twists or discontinuities as shown below. Interest Years to Maturity Conclusion The essay has provided explanations of the relationship between interest rates and term to maturity of different financial instruments, such as bonds and shares and how the relationship explains the shape of a yield curve. The essay has also explains the different theories of the term structure and how they explain the shape of a yield curve. Overall, it can be deduced that interest rates and term structure together provides market participants with useful information that can assist them in projecting events that are likely to occur in an economy in order to adjust their policies accordingly. References Blake, D.  (2000). Financial market analysis. West Sussex: John Wiley & Sons Ltd. Cecchetti, G.  S. (2008).  Money, banking, and financial markets. New York: McGraw‐ Hill. Choudhry, M. (2011). Analysing and interpreting the yield curve. Upper Saddle River: John Wiley & Sons. Elton, E. J., & Gruber M. J. (2009). Modern portfolio theory and investment analysis, 5th edition. West Sussex: John Wiley & Sons. Geiger, F. (2011). The yield curve and financial risk premia: Implications for monetary policy. London: Springer Science & Business Media. Mishkin, S. F., & Eakins, G. S. (2012). Financial markets and institutions, 7th edition. Pearson Prentice Hall. Read More