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Term Structure of Interest Rates【Deric Business Class】 - YouTube
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hey guys welcome to derek business class
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in this video I'm gonna explain to you
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the term structure of interest rates
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first what is interest rate the interest
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rate or required return represents the
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price of money this is the compensation
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that a demander of funds must pay to a
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supplier interest rates act as a
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regulating device that controls the flow
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of money between suppliers and demanders
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of funds when funds are lent the cost of
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borrowing is the interest rate when
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funds are raised by issuing stocks or
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bonds the cost the company must pay is
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called the required return which
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reflects the suppliers expected return
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the central bank regularly assesses
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economic conditions and when necessary
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initiate actions to change interest
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rates to control inflation and economic
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growth one of the most popular theories
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for this topic is Fisher effect or
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Fisher hypothesis the Fisher effect
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defines the relationship between nominal
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interest rates real interest rates and
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inflation rate the nominal interest rate
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or quoted rate equals to real interest
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rate plus expected inflation rate plus
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real interest rate times expected
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inflation rate by approximation nominal
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rate equals real rate plus expected
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inflation rate specifically the real
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interest rate is the rate that creates
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an equilibrium between a supply of
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savings and the demand for investment
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funds in a perfect world in this context
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a perfect world is one in which there is
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no inflation where suppliers and
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demanders have no liquidity preference
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and where all outcomes are certain let's
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take an example if you require 10% real
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return and expect inflation to be 8% or
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is a nominal rate by using the formula
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you will get 18.8% or by approximation
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the answer is around 18% now I'm going
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talk about the term structure of
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interest rate and the yield curves term
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structure of interest rates is the
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relationship between the remaining time
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to maturity and the yield to maturity of
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a bond time to maturity is the length of
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holding period of the bond while the
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yield to maturity is the expected return
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on a bond whereas the yield curve is a
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graph that represents the relationship
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between the remaining time to maturity
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and the yield to maturity of a bond at a
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given point in time there are two types
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of yield curve first type upward-sloping
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yield curve or normal yield curve that's
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when the long-term interest rate is
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higher than the short-term interest rate
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second type downward sloping yield curve
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or inverted yield curve that's when the
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long-term interest rate is lower than
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the short-term interest rate there are
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three theories used to explain the term
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structure of interest rate expectations
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theory market segmentation theory and
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liquidity preference theory
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the first theory expectations theory
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this theory suggests that the shape of
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the yield curve is based upon investors
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expectations of the future direction of
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inflation and interest rates if there is
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an expectation of higher future
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inflation investors will ask for higher
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interest rates on the long-term bond to
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compensate for risk so you will get an
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upward sloping yield curve however if
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there is an expectation of lower future
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inflation investors will only need lower
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interest rates on the long-term bond so
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you will get a downward sloping yield
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curve in general the strong relationship
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between inflation and interest rates
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supports this theory the second theory
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market segmentation theory this theory
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suggests that the shape of yield curve
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is based upon the supply and demand for
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funds and the markets for different
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maturity bonds are completely segmented
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if the demand is more than the supply
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for short term fund it means more people
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are looking for money in the short term
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so short-term interest rate will become
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higher in other words long term interest
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will become lower therefore you will get
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a downward sloping yield curve but if
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the demand is less than the supply for
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short term fund it means more people are
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supplying money in the short term so
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short term interest rate will become
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lower
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in other words long term interest will
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become higher therefore you will get an
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upward sloping yield curve the third
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theory liquidity preference theory this
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theory contends that long-term interest
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rates tend to be higher than short-term
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rates in which you will get an upward
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sloping yield curve the reason is
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because investors perceive long-term
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bonds to be riskier than short-term
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bonds if investors money is tied up for
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longer periods of time they will have
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less liquidity and demand higher
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interest rates to compensate for the
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risk simply speaking investors will not
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tie their money up for longer periods
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unless they are paid more to do so
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on the other hand borrowers are
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generally willing to pay more for
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long-term funds because they can lock an
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at a rate for a longer period of time
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and avoid the need to roll over the debt
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as a conclusion to interpret the shape
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of yield curve you will get an upward
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sloping yield curve if there is higher
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inflation expectation or there is
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greater supply of shorter term loans or
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lender preference for shorter maturity
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loans you will get a downward sloping
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yield curve if there is lower inflation
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expectation or greater supply of
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longer-term loans or lender preference
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for longer maturity loans
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alright that's all for this video thanks
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for watching see you in the next one bye
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