Theories of Term Structure: Pure Expectations, Liquidity Preference Term structure refers to how interest rates are linked to maturity in fixed-income se...
Term structure refers to how interest rates are linked to maturity in fixed-income securities.
There are two main theoretical perspectives on term structure:
1. Pure Expectations Theory:
This theory assumes that investors are rational, meaning they fully anticipate future interest rate changes and use this information to adjust the price of a security accordingly.
Under this theory, higher coupon payments result in higher prices, reflecting the investor's expectation of receiving higher future returns.
Conversely, lower coupon payments result in lower prices, reflecting the expected lower returns.
2. Liquidity Preference Theory:
This theory argues that investors are risk-averse and prefer to hold short-term securities due to their perceived lower risk.
Consequently, they require higher interest rates for longer-term bonds due to the increased uncertainty involved.
This higher risk premium reflects the additional compensation investors require for lending money for a longer period.
Both these theories can help explain the observed non-linear relationship between maturity and interest rate.
Additionally:
The term premium, the difference between the current market price and the par value of a security, can be explained by considering the risk and liquidity characteristics of the security.
High credit ratings of a company issuing bonds can lead to lower volatility and a lower term premium, reflecting greater liquidity.
Inflation can erode the purchasing power of fixed-income returns, leading to a lower nominal term structure and higher real-world interest rates.
Examples:
A long-term government bond with a low coupon payment but a high maturity will likely have a higher price compared to a long-term bond with a high coupon payment but a shorter maturity.
A high-quality corporate bond with a lower risk profile might have a lower price than a low-quality bond despite having the same maturity.
When an interest rate rises, both theories predict the bond price will decrease. However, the liquidity preference theory might predict a larger decrease in price due to the higher risk aversion