Term Structure of Interest Rates

Interest rates are a factor of the current rate, expected inflation and future interest rates. There are three main theories attempting to explain how interest rates vary with time.

Table of contents

1 Market Expectations (Pure Expectations) Theory 2 Liquidity Preference Theory 3 Market Segmentation Theory

Market Expectations (Pure Expectations) Theory

Interest rates are quoted according to the associated time periods. A CD (Certificate of Deposit) for 2 years will pay a different rate than a CD for 1 year. The Market Expectations theory states that a CD for 2 years will pay the same interest rate as a CD for 1 year followed by another CD for 1 year.

Liquidity Preference Theory

This theory states that borrowers pay an incentive to lenders inorder to obtain funds for longer duration. This explains why interest rates for longer term periods are higher than shorter time periods.

Market Segmentation Theory

This theory states that investors prefer to operate within their own segment (of time periods)