Term structure of interest rates - Research Paper Example

The tendency to slope upwards occurs when short-term rates of interest are low, and the tendency to slope downwards occurs when short-term rates of interest are high. Thirdly, in most cases, the yield curve slopes upwards (Fisher, 6). The paper shall also present a model that can be used for the pricing of bonds. The model is known as Vasicek’s Model. According to economic theory, one primary factor used to explain the differences in interest rates on various securities might be variations in their terms.

That is in terms of lengths of time before maturity. The term structure of interest rates refers to the association between the terms of securities and their market rates of interest (Russell, 36). Economists usually use a diagram known as a yield curve to designate the term structure of interest rates on particular types of securities at a certain point in time. Consequently, the theory of the yield curve is used to describe the term structure of interest rates (Russell, 36). The determinants of the relationship between returns on securities and their terms of maturity have remained an issue of interest, for economists for a long time.

By providing a conclusive schedule of interest rates over a period, the term structure captures the market’s speculations of future events. A description of the term structure offers a means of extracting this information and predicting how variations in the underlying variables affect the yield curve (Cox, Ingersoll, and Ross, 385). In an attempt to understand the term structure of interest rates, this paper shall explore three common theories that have long been used to explain the term structure.

These theories include the Expectations Hypothesis, the Segmented Markets Theory, and the Preferred Habitat or Liquidity Premium Theory. The expectations hypothesis has several variations. However, they all place a predominant focus on holding-period returns or the expected values of future spot