Academic journal article Federal Reserve Bank of St. Louis Review

Understanding the Term Structure of Interest Rates: The Expectations Theory

Academic journal article Federal Reserve Bank of St. Louis Review

Understanding the Term Structure of Interest Rates: The Expectations Theory

Article excerpt

formulas are adequate for most purposes. In the case described on pp. 42 of the text, for instance, the yield given by the exact formula is 8.743 percent, compared to the linearized figure of 8.750 percent.

The expectations theory can also be shown to imply that, if !Mathematical Expression Omitted^ is the current N-period term-adjusted rate, and !Mathematical Expression Omitted^ is the current K-period rate, then !Mathematical Expression Omitted^, the term-adjusted rate on (N-K)-period securities that is expected to prevail at date K, satisfies the relationship THE INTEREST RATES on loans and securities provide basic summary measures of their attractiveness to lenders. The role played by interest rates in allocating funds across financial markets is very similar to the role played by prices in allocating resources in markets for goods and services. Just as a relatively high price of a particular good tends to draw physical resources into its production, a relatively high interest rate on a particular type of security tends to draw funds into the activities that type of security is issued to finance. And just as identifying the factors that help determine prices is a key area of inquiry among economists who study goods markets, identifying the factors that help determine interest rates is a key area of inquiry for those who study financial markets.

Economic theory suggests that one important factor explaining the differences in the interest rates on different securities may be differences in their terms--that is, in the lengths of time before they mature. The relationship between the terms of securities and their market rates of interest is known as the term structure of interest rates. To display the term structure of interest rates on securities of a particular type at a particular point in time, economists use a diagram called a yield curve. As a result, term structure theory is often described as the theory of the yield curve.

Economists are interested in term structure theory for a number of reasons. One reason is that since the actual term structure of interest rates is easy to observe, the accuracy of the predictions of different term structure theories is relatively easy to evaluate. These theories are usually based on assumptions and principles that have applications in other branches of economic theory. If such principles prove useful in explaining the term structure, they might also prove useful in contexts in which their relevance is less easy to evaluate. One theory of the term structure that will be described here, for example, suggests that a behavioral trait called risk aversion may play a major role in determining the shape of the yield curve. If subsequent research lends credence to this theory, economists may give more emphasis to risk aversion in constructing theories of other aspects of financial market operation.(1)

A second reason why economists are interested in term structure theories is that they help explain the ways in which changes in short-term interest rates--rates on securities with relatively short terms--affect the levels of long-term interest rates. Economic theory suggests that monetary policy may have a direct effect on short-term interest rates, but little, if any, direct effect on long-term rates. It also suggests that long-term rates play a critical role in a number of important economic decisions, such as firms' decisions about investment, and households' decisions about purchases of homes and other durable goods. Theories of the term structure may help explain the mechanism by which monetary policy affects these decisions.(2)

A third reason economists are interested in the term structure is that it may provide information about the expectations of participants in financial markets. These expectations are of considerable interest to forecasters and policymakers. Market participants' beliefs about what may happen in the future influence their current decisions; these decisions, in turn, help determine what actually happens in the future. …

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