Yield Curve Theories Impacting Interest Rates

Subject: Finance
Pages: 1
Words: 273
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There exist a number of yield curve theories: expectation theory, horizon premium theory, inflation premium theory, and market segmentation theory.

Market segmentation theory assumes that investors limit their investments to certain segments of the market or segments of the yield curve. It assumes that it is costly for the investor to have know-how on all different segments of the market. Therefore, they tend to focus on the segment they are aware of. There is also an assumption of the regulation of the market such as limiting the type of investment that individuals and companies are allowed to make.

Inflation premium theory assumes that investors view future interest rates or inflation in an inflationary environment to be uncertain. Therefore, they will demand or need a high interest rate for long-term investments. This affects the value of long-term assets as compared to short-term assets. This theory is applicable mainly in countries where there is a two-digit inflation rate. In stable economies, this theory may not hold water.

The expectation theory assumes that investors will view interest rates as per their expectation of the return of their money. If the investors feel that the interest rate is likely to go up, then the slope of the yield curve will appreciate and vice versa. If they feel that the conditions of yesterday, today, and tomorrow will remain stable, then the yield curve will be constant as today, yesterday, and tomorrow.

The yield curve always shows how the interest rate will change from the time of issue to the time of maturity.