1. Explain the term structure of interest rates
The term structure of interest rates, also known as the yield curve, refers to the relationship between the interest rate and the time to maturity of the debt for a given borrower in a given currency.
Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed-income securities, the yield curve is a measure of the market's expectations of future interest rates given the current market conditions.
The yield curve can be upward-sloping, flat or hump-shaped. There are three main theories attempting to explain the shape of the yield curve:
(1) Market expectations (pure expectations) hypothesis
This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. Specifically, rates on a long-term instrument are equal to the geometric mean of the yield on a series of short-term instruments.
According to the expectations hypothesis, if future interest rates are expected to rise, then the yield curve slopes upward, with longer term bonds paying higher yields. However, if future interest rates are expected to decline, then this will cause long term bonds to have lower yields than short-term bonds, resulting in an inverted yield curve.
This theory perfectly explains the observation that yields usually move together, and that short-term yields are more volatile than long-term yields.
However, it does not explain why the yields on long-term bonds are usually higher than short-term bonds. This could only be explained by the expectations hypothesis if the future interest rate was expected to continually rise, which isn’t plausible nor has it been observed, except in certain brief periods.
(2) Liquidity preference theory
The Liquidity Preference Theory, also known as the Liquidity Premium Theory, asserts that long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds, called the term premium or the liquidity premium.
There are 2 risks with holding bonds that increases with the term of the bond: inflation risk and interest rate risk. Both the inflation rate and the interest rate become more difficult to predict farther into the future. Inflation risk reduces the real return of the bond. Interest rate risk is the risk that bond prices will drop if interest rates rise, since there is an inverse relationship between bond prices and interest rates. Of course, interest rate risk is only a real risk if the bondholder wants to sell before maturity, but it is also an opportunity cost, since the long-term bondholder forfeits the higher interest that could be earned if the bondholder’s money was not tied up in the bond. Therefore, a longer term bond must pay a higher risk premium to compensate for the bondholder for the greater risk.
A bond’s yield can theoretically be divided into a risk-free yield and the risk premium. The risk-free yield is simply the yield calculated by the formula for the expectation hypothesis. The risk premium is the liquidity premium that increases with the term of the bond. Hence, the yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little, and so the liquidity premium theory of the term structure of interest rates explains the generally upward sloping yield curve for bonds of different maturities.
(3) Market segmentation theory
In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined largely independently. If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments. Therefore, the market for short-term instruments will receive a higher demand. Higher demand for the instrument implies higher prices and lower yield. This theory explains the predominance of the normal yield curve shape. However, because the supply and demand of the two markets are independent, this theory fails to explain the observed fact that yields tend to move together.
如何分析金融体系与社会经济繁荣之间的关系？
金融体系为人与人之间的信任提供了一套机制安排。现代经济的繁荣是建立在开放与合作基础上的，而合作的前提便是信任。信任使合作可以更深入更广泛的进行。
当资源投入于经济运转中时，总会受到各种各样的限制。货币的出现使社会财富有了一般性的代表
How to analyze the relationship between financial system and the development of economy?