the amount of returns that an investor can earn from an investment, as well as the future changes as a result of economic risk associated with that particular investment can be established. For this reason, the above curve facilitates a significant comparison in bonds values.
The term structure of interest rates is also the yield curve and is a central element in modern financial and monetary economics. It is the variation of the bonds’ yield with identical risk profiles with these bonds’ terms2. The yield curve shows the relationship between bonds yield to maturity and the effective maturity. Bonds with longer maturities are considered to have higher yields. However, there are also opinions that the yield curve may be flat showing that the yield curve remains the same irrespective of the bonds’ maturity. Also, in some cases, bonds with short-term maturities have their yield curves inverted implying that they are higher than those of long-term bonds3. Notes that the bonds’ yield curve is influenced by several factors among them the fiscal policies, inflation, economic conditions, tax policies, foreign exchange rates, expected forward rates, bonds’ credit rating and foreign capital inflows as well as outflows.
The term structure of interest rates bears three identifiable features. They include higher volatility of yields on short-term bonds than long-term bonds; change in yields of various bonds move in the same directions; and the long-term bonds have higher yields. Several theories have been advanced to explain these characteristics. They are broadly classified as the market segmentation theory and expectations theories, which are the preferred habitat theory, the liquidity premium, and the pure expectation theory.
Given that bonds have some set durations, sellers and buyers frequently have preferred maturities. The bond buyers prefer maturities that coincide with when they need money or with their liabilities while the bond sellers want maturities ...Show more