The Slope and Shape of the Yield Curve
The activities of strategic financial planning require an insight into the tendencies in a certain national or international economy. Particularly, the slope and the shape of yield curve has been argued by many scientists to be a reliable predictor of future real economic activity, as argued by Estrella (2005). Yield curve is a geometrical representation of the relationship between yield and term to maturity.
This relationship is also called term structure of interest rates. Yield curve represents a line, which, at a set point of time, plots the interest rates of bonds with equal credit quality, but having different maturity rates (Investopedia, 2003). Equal credit quality means that constructing a yield curve requires as many similarities between the bonds used as possible to achieve accuracy. As argued by Estrella, the yield curve has been reported to predict every recession in the U.S. economy since 1950 with only one inaccuracy (2005). Theories Explaining the Slope and Shape of the Yield CurveThere are several theories explaining the slope and the shape of the yield curve, which give insight into the relationships between interest rates and terms to maturity. One of such theories is the Expectation Theory. This theory provides explanation that the slope of the yield curve is determined by the expectations of the investors about the interest rates in future. Among the basic postulates of this theory is the one, which states that investors expect to receive the same amount of income by investing into a one-year bond at present and then reinvesting the returned loaned funds, after one year, into a new one-year bond in comparison to investing into a two-year bond at present.
According to The Expectation Theory, an upward slope of the yield curve shows that investors expect the rise of interest rates in future. On the contrary, a downward slope of the yield curve implies that the investors expect the future fall of interest rates. The expectation theory is criticized for not taking into account the risk or liquidity premium, which is influential in practice on the investors’ decisions to invest into long-term bonds.Market Segmentation Theory is another approach to explanation of the term structure of interest rates or its graphical representation, yield curve. Market Segmentation Theory arguments that the majority of the investors have specific set preferences in concern of the length of maturities they observe as a good investment. This theory implies that there is no obligatory relationship between long and short-term interest rates, which represent two different markets of securities with different supply and demand patterns.Preferred Habitat Theory take the risk or liquidity premium into account in observing the choices of investors. This theory states that investor choses to invest funds into a security with the maturity being outside their terms of preference only in case of compensation for the taken additional risk, which is represented by a certain interest premium.
For example liquidity premium is the additional interest paid …