Financial Markets and Institutions (2-downloads)

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Term to Maturity

Term to Maturity

Term to Maturity

Term to Maturity

(a) Future short-term interest rates

expected to rise

(b) Future short-term interest rates

expected to stay the same

(c) Future short-term interest rates

expected to fall moderately

(d) Future short-term interest rates

expected to fall sharply

Yield to

Maturity

Yield to

Maturity

Yield to

Maturity

Yield to

Maturity

F I G U R E   5 . 6

Yield Curves and the Market’s Expectations of Future Short-

Term Interest Rates According to the Liquidity Premium Theory

a different view. It shows that the term structure contains quite a bit of informa-

tion for the very short run (over the next several months) and the long run (over sev-

eral years) but is unreliable at predicting movements in interest rates over the

intermediate term (the time in between).

6

Research also finds that the yield curve

helps forecast future inflation and business cycles (see the Mini-Case box).

Summary

The liquidity premium theory is the most widely accepted theory of the term struc-

ture of interest rates because it explains the major empirical facts about the term struc-

ture so well. It combines the features of both the expectations theory and market

6

Eugene Fama, “The Information in the Term Structure,” Journal of Financial Economics 13

(1984): 509–528; Eugene Fama and Robert Bliss, “The Information in Long-Maturity Forward Rates,”

American Economic Review 77 (1987): 680–692; John Y. Campbell and Robert J. Shiller,

“Cointegration and Tests of the Present Value Models,” Journal of Political Economy 95 (1987):

1062–1088; John Y. Campbell and Robert J. Shiller, “Yield Spreads and Interest Rate Movements: A

Bird’s Eye View,” Review of Economic Studies 58 (1991): 495–514.

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Part 2 Fundamentals of Financial Markets

segmentation theory by asserting that a long-term interest rate will be the sum of a

liquidity (term) premium and the average of the short-term interest rates that are

expected to occur over the life of the bond.

The liquidity premium theory explains the following facts: 

1. Interest rates on bonds of different maturities tend to move together over time.