Introduction to Finance

Inflation
Number 
of Years
Cumulative 
Inflation
Year 1
2%
×
1
=
2%
Year 2
4%
×
1
=
4%
Years 3–10
4.25%
×
8
=
34%
Total inflation
40%
Total years
10
Average inflation (40% ÷ 10 years)
4%
These are only simple arithmetic averages. Technically, we have ignored the impact of 
the compounding of infl ation rates over time. The concept of compounding is presented in 
Chapter 9, which focuses on the time value of money.
The 
liquidity preference theory
holds that investors or debt instrument holders prefer 
to invest short term so that they have greater liquidity and less maturity or interest rate risk. 
Lenders also prefer to lend short term because of the risk of higher infl ation rates and greater 
uncertainty about default risk in the future. Borrowers prefer to borrow long term so that they 
have more time to repay loans. The net result is a willingness to accept lower interest rates on 
short-term loans as a trade-off for greater liquidity and lower interest rate risk.
The 
market segmentation theory
holds that securities of diff erent maturities are not 
perfect substitutes for one another. For example, commercial banks concentrate on holding 
short-term government securities in an eff ort to match the short-term maturities of their 
demand and other deposit liabilities. On the other hand, the nature of insurance company and 
pension fund liabilities allows these fi rms to concentrate holdings in long-term securities. 
Thus, supply-and-demand factors in each market segment aff ect the shape of the yield curve. 
Thus, in some time periods, interest rates on intermediate-term Treasury securities may be 
higher (or lower) than those for both short-term and long-term Treasuries.