Financial Markets and Institutions (2-downloads)

Yield Curves

The

Wall Street Journal publishes a daily plot of the yield curves for Treasury

securities, an example of which is presented here. It is found in the “Money

and Investing” section.

The numbers on the vertical axis indicate the interest rate for the

Treasury security, with the maturity given by the numbers on the horizontal

axis. For example, the yield curve marked “Wednesday” indicates that the

interest rate on the three-month Treasury bill was 0.16%, while the two-year

bond had an interest rate of 0.87%, and the 10-year bond had an interest

rate of 3.55%. The yield curves shown for one year ago is also very steep.

Source: Wall Street Journal. Copyright 2010 by DOW JONES & COMPANY, INC. Reproduced with permission of DOW JONES & 

COMPANY, INC. via Copyright Clearance Center.

F O L L O W I N G   T H E   F I N A N C I A L   N E W S

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Part 2 Fundamentals of Financial Markets

way to seek a better understanding of the term structure is to combine features of

both theories, which leads us to the liquidity premium theory, which can explain all

three facts.

If the liquidity premium theory does a better job of explaining the facts and is

hence the most widely accepted theory, why do we spend time discussing the other

two theories? There are two reasons. First, the ideas in these two theories lay the

groundwork for the liquidity premium theory. Second, it is important to see how econ-

omists modify theories to improve them when they find that the predicted results are

inconsistent with the empirical evidence.

Expectations Theory

The expectations theory of the term structure states the following commonsense

proposition: The interest rate on a long-term bond will equal an average of the short-

term interest rates that people expect to occur over the life of the long-term bond.

For example, if people expect that short-term interest rates will be 10% on aver-

age over the coming five years, the expectations theory predicts that the interest rate

on bonds with five years to maturity will be 10%, too. If short-term interest rates were

expected to rise even higher after this five-year period, so that the average short-

term interest rate over the coming 20 years is 11%, then the interest rate on 

20-year bonds would equal 11% and would be higher than the interest rate on five-

year bonds. We can see that the explanation provided by the expectations theory

for why interest rates on bonds of different maturities differ is that short-term inter-

est rates are expected to have different values at future dates.

The key assumption behind this theory is that buyers of bonds do not prefer

bonds of one maturity over another, so they will not hold any quantity of a bond if

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