CHAPTER 7: Understanding Interest Rates: The Term

Structure of Interest Rates

FOCUS OF THE CHAPTER
Various theories of the term structure of interest rates, such as the expectations
hypothesis, market segmentation hypothesis, and liquidity premium theory, are the
focus of this chapter, The possible shapes of the yield curve and some stylized facts
about the yield curve are also discussed.

Learning Objectives:

Explain why bond yields differ according to the length of time before they mature
List some of the key properties of a term structure of interest rates
Explain how a yield curve is defined
Describe how the expectations hypothesis is formulated
Identify some of the anomalies in yield curve behaviour
Explain how the liquidity premium hypothesis is formulated
Determine how the segmented markets and preferred habitat hypotheses are
formulated

SECTION SUMMARIES
The Term Structure of Interest Rates
The term structure of interest rates is the structure of interest rates on instruments that
differ only in their term to maturity. On a diagram, the term structure of interest rates is
given by a yield curve which depicts the relationship between the yield (yield to
maturity) and the term to maturity. On such a diagram, normally, the yield is measured
along the vertical axis, and the term to maturity is given by the horizontal axis. In
general, the yield on a long-term bond is higher than the yield on a short-term bond, and
therefore, the yield curve is upward-sloping. However, the yield curve can take other
shapes, such as downward-sloping or flat. Several hypotheses have been developed to
explain the possible shapes of the yield curve (or the term structure of interest rates).
The Expectations Hypothesis: The decision of investors to hold short-term or long-term
bonds depends on their expectations about future interest rates. According to the
expectations hypothesis, the yield on a long-term bond is the average of expected shortterm interest rates. Investors are indifferent between long-term and short-term bonds as
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long as the annual yield on the long-term bond is equal to the average of the expected
short-term yields, a condition given by the following equation:
Rn = (R1 + E11 + E12 +... + E1n-1)/n
where n is the number of years to maturity, Rn is the annual yield on an n-year bond (say,
a long-term bond), R1 is the yield on a one-year bond (say, a short-term bond) maturing
in one year, and E11, E12, and E1n-1 are the expected yields on a short-term bond maturing
in one, two, and n-1 years from today, respectively.
If the expectations hypothesis is correct, the spread (or the difference between the
long-term and short-term interest rates) provides investors with a forecast of future shortterm interest rates and helps them to predict the future course of short-term rates.
Expectations of higher (lower) future short-term interest rates result in an upward-sloping
(downward-sloping) yield curve, while expectations of constant future short-term rates
produce a flat yield curve.
The Role of the Real Interest Rate: The yield curve conveys information about changes
in expected future inflation and the real interest rate. With the help of the Fisher equation,
one can show how changes in inflation expectations and real interest rates influence the
position and shape of the yield curve.
Consider the Fisher equation (R = + e), which states that the nominal rate of
interest (R) is the sum of the real interest rate () and the expected rate of inflation (e)). If
the real interest rate () is constant, the change in nominal interest rate (R) must equal
the change in the expected rate of inflation (e).
Using the Fisher equation, it can also be shown that the spread between the
nominal interest rates of a short-term bond and those of a long-term bond equals the
difference between the expected rates of inflation. Suppose the real interest rate () is
constant. Using the Fisher equation, the nominal rate of interest on a short-term (oneyear) bond (R1) can be written as R1 = + e1 , and the nominal rate of interest on a longterm (two-year) bond (R2) can be written as R2 = + e2. The difference between R2 and
R1 (R) equals the difference between the expected rates of inflation e2 and e1 (e ):
R2 - R1= (+e2 ) - (+e1) = e2 - e1 = e
R = e
A sudden and permanent increase (decrease) in the expected rate of inflation
increases (decreases) the nominal interest rates on both long-term and short-term bonds
by the increase (decrease) in the expected rate of inflation, and, therefore, the yield curve
shifts upward (downward). If the expected rate of inflation (e) is unchanged, changes in
nominal interest rates can be explained only by changes in real interest rates.
Yield Curve Puzzles: Many believe that the expectations hypothesis provides an accurate
explanation for various possible shapes of the yield curve. However, the expectations
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hypothesis may not be easily or satisfactorily applied to explain certain stylized facts
about the yield curves. Three such stylized facts are:
1) The yield curve is generally upward-sloping. According to the expectations
hypothesis, an upward-sloping yield curve implies that investors almost always expect
higher future interest rates.
2) The yield curve tends to shift over time. This may be due to the government or to
individuals decisions to shift their bond holdings from long-term to short-term, or viceversa. Such decisions are often prompted by expectations of future inflation.
3) The slope of the yield curve tends to predict future economic activity. It has been
found that the yield curve has the ability to predict recessions and, thus, is linked to the
state of the business cycle. It has also been found that the size of the spread is linked to
the future economic growth rate. In Canada, recessions have been preceded by a falling
or negative spread, and expansions (recovery phase of business cycle) have been
preceded by a rising or positive spread.
Competing Views of the Term Structure: The liquidity premium theory, market
segmentation theory, and preferred habitat theory provide alternative views to the
expectations theory in explaining the term structure of interest rates.
The Liquidity Premium Theory: According to this theory, long-term bonds are relatively
less marketable (less liquid) than short-term bonds. Therefore, the holders of long-term
bonds expect a liquidity premium (an additional yield for accepting lower liquidity, also
called term premium), as indicated in the following equation:
Rn = (R1 + E11 + E12 +... + E1n-1)/n + LP
where LP is the liquidity premium. The rest of the terms are defined earlier in the section
on the expectations hypothesis. Note that the term premium may capture a variety of
factors, referred to as risk.
Market Segmentation and Preferred Habitat Views:
Market Segmentation View: According to the market segmentation view, long-term and
short-term bonds are not substitutes. As such, their markets are separated (segregated)
from each other. Changes in market forces (supply and demand) in one market have no
effect on the other. The short-term interest rate is determined in the short-term bond
market, while the long-term interest rate is determined in the long-term bond market.
Preferred Habitat View: According to this view, a certain degree of substitutability exists
between long-term and short-term bonds. But investors have a distinct preference for
certain maturities. An investors preferred habitat is the term to maturity (short-term or
long-term) for which that investor has a distinct preference. An investor's willingness to
accept a term to maturity different from the preferred habitat (a less preferred habitat)
depends on the size of the term premium the investor can earn. A term premium is an
additional yield for accepting a less-preferred maturity. If the term premium is large
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enough, an investor who has a particular preference for a short-term bond will purchase a
long-term bond.

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MULTIPLE-CHOICE QUESTIONS
1. The term structure of interest rates is the structure of interest rates on bonds that differ
only in terms of
a) purchase price.
b) income risk.
c) term to maturity.
d) liquidity.
2. The graphic display of the relationship between the rate of return and the term to
maturity is called
a) the yield curve.
b) the supply curve for bonds.
c) the Phillips curve.
d) the demand curve for bonds.
3. The yield on a government bond maturing in one year is 6%, and the expected yield on
a government bond maturing in one year from today is 8%. According to the expectations
hypothesis, the yield on a government bond maturing in two years is:
a) 14%.
b) 2%.
c) 7%.
d) 8%.
4. Which of the following is not a theory of the term structure of interest rates?
a) expectations hypothesis
b) permanent income hypothesis
c) liquidity premium theory
d) market segmentation hypothesis
5. According to the expectations hypothesis the yield on
a) a short-term bond is an average of the expected yields on long-term bonds.
b) a long-term bond is the average of expected yields on short-term bonds.
c) a short-term bond is the difference between the long-term yield and the inflation rate.
d) a long-term bond is the sum of the short-term yield and the risk premium.
6. According to the expectations hypothesis, the expectation of falling short-term interest
rates results in
a) a downward-sloping yield curve.
b) an upward-sloping yield curve.
c) a flat (horizontal) yield curve.
d) a hump-shaped yield curve.
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7. If the real interest rate remains constant, the spread between short-term and long-term
yields is equal to
a) changes in expected future inflation rates.
b) the liquidity premium.
c) the difference between long-term and short-term bond prices.
d) changes in the foreign rate of inflation.
8. The liquidity premium theory of the term structure of interest rates assumes that
a) short-term and long-term bonds are perfect substitutes.
b) long-term bonds are relatively less liquid (less marketable) than short-term bonds.
c) short-term bonds are relatively less liquid (less marketable) than long-term bonds.
d) short-term and long-term bonds are perfect complements.
9. Through the operation of the Fisher Effect, a permanent increase in the expected rate of
inflation
a) shifts the yield curve downward.
b) shifts the yield curve upward.
c) leaves the yield curve unaffected.
d) changes the slope of the yield curve from positive to negative.
10. According to the market segmentation hypothesis, short-term and long-term bonds
a) are perfect substitutes.
b) are imperfect substitutes.
c) are not substitutes for each other.
d) are complementary to each other.

PROBLEMS
1. Suppose the following interest rate structure was observed in 2000 and 2001:
Yield (%)
Bond

2000
2001
3-month treasury bill
14.00
1-year government bond
14.50
3-year government bond
14.75
5-year government bond
15.00
10-year government bond
15.30
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12.00
12.50
12.75
13.00
13.30

a) In light of the expectations hypothesis, explain what the yield curves say about future
interest rates.
b) If real interest rates were the same in both years, what might have caused the shift in
the yield curve?
2. Consider the following forecasts of future interest rates:
Yield
E13
%
5.2

R1
E14
6.6
5

E11

E12

6.4

5.6

Using the expectations hypothesis, predict the shape of the yield curve.
3. What would be the possible explanation for a flat yield curve given by the following
theories?
a) expectations hypothesis
b) market segmentation hypothesis
c) liquidity premium theory
4. If you thought an economic expansion was imminent, would you be better off holding
short-term or long-term bonds? Explain.

ANSWER SECTION
Answers to multiple-choice questions:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

c
a
c
b
b
a
a
b
b
c

(see page 113)

(see page 113)
(see pages 114, 115)
(see pages 114, 125, 126)
(see page 115)
(see page 117)
(see pages 118-119)
(see pages 125-126)
(see pages 119)
(see page 126)

Answers to problems:

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1. a) In each of the two years, the yield increases as the term to maturity increases. This
shows that the yield curves in the two years are normal (upward-sloping). According to
the expectations hypothesis, a normal yield curve is the result of expectations of rising
future short-term interest rates. Therefore, this normal yield curve indicates increases in
future interest rates.
b) On a diagram, the yield curve for 2001 lies above the yield curve for 2000,
indicating an upward shift in the yield curve. Using the Fisher equation, the yield (rate of
interest) for a given term to maturity can be stated as the sum of the real interest rate and
the expected rate of inflation. The data show that, between the two years, the yield on
each type of bond has increased by 2%, causing a parallel shift in the yield curve. If the
real interest rate remained the same, the increase in yield must be equal to the change in
the expected rate of inflation. Therefore, the shift in the yield curve may have been
caused by an increase in the expected rate of inflation.
2. According to the given data, the expected future rates of return (E11, E12, E13, and E14 )
are decreasing. The expectations hypothesis predicts a downward-sloping yield curve in
this situation. This can be verified by the long-term rates of return predicted by the
expectations hypothesis.
The following rates of return can be calculated from the data using the equation:
Rn = (R1 + E11 + E12 +... + E1n-1)/n
Yield
R4

R3

6.4

5.6

R5

%
5.2

R2
5

These data show clearly that the yield curve is downward-sloping (has a negative slope).
3. a) According to the expectations hypothesis, the yield curve is flat because future
short-term interest rates are expected to remain the same.
b) According to the market segmentation hypothesis, the yield curve is flat because
market forces in short-term and long-term bond markets determine the same interest rate
(yield), even though the markets are segregated from each other.
c) According to the liquidity premium theory, the yield curve is flat because the
liquidity premium is zero.
4. The expectation of an economic expansion generates an increase in the supply of
bonds, long-term bonds in particular. This implies a decrease in the price of long-term
bonds. The price of a bond and the yield are inversely related. Therefore, the decrease in
the price of long-term bonds implies an increase in the yield on long-term bonds.
Therefore, I would be better off holding long-term bonds rather than short-term bonds.

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