Theories of interest rate determination are critical for every financial analyst as they in detail explain the changes experienced in the economy. Some of the changes in the economy are retail trends, interest rates, and unemployment patterns (Frenkel & Johnson, 2013). The theories, therefore, equip the investors with some confirmation of where the savings are, where the economies are from and the projections given of where the economy is heading. For the economic indicators to have any predictive value for the investors, it is paramount for the investors market indexes to be current and must be looking forward to giving discount current values in accordance to the future expectations. Four distinctive theories explain the structure if interest rates namely; expectation theory, segmented market theory, liquidity premium theory and preferred habit theory.
Segmentation market theory explains many investors are characterized to be very risk averse and have a tendency to invest in a security of a given maturity irrespective of the anticipated differentials that are as a result of restrictions governed by law, the custom of preferences to specific certain securities (Keynes, 2016). Therefore, based on the theory what determines the long-term rates is the supply and demand of the long-term funds also the short-term rates are solely determined by the supply and demand of the identified little resources. Example the commercial banks whose liability are mainly short-term ones only invest in the short-term securities. Thus they are not exposed to the risk of interest that may result as consequent fall in the market value of long-term investments like the bonds. Evidently, based on the theory, the long-term investments significantly affect the short-term investments and vice verse. Therefore, the approach focuses on the demand size suggest the changes in the expected relative supply of the long-term bonds affects the shape of the yield curve.
Pure expectation theory is primarily driven by the expectation of the investors who are assumed to be risk neutral with their interest solely on the expected return on their investments (Keynes, 2016). With little reservation made on the dangers, the interest rates are exclusively driven by the future expectations about the future short-term rates. Therefore, it is possible for the yield curve to either has an upward sloping or a downward sloping depending on the anticipation. The spot rates are average rates and with the event of inflation expected the yield curve is supposed to be upward sloping. Therefore, the theory can be noted to be an excellent illustration of trading in the efficient market where there is the availability of unique information and minimal trading costs. However, this is contrary to the real world where the expectation theory doesnt explain the general upward slope of the yield.
Liquidity premium theory is often regarded as an extension of pure expectation theory. Usually, the approach is considered to be the difference between the forward rate and the expected future rate (Cox, Ingersoll Jr & Ross, 2005). Based on the assumption the investors are noted to dislike the uncertainty that is associated with the longer-term investment. Therefore, to counter the possibility the investors have introduced premiums on the long-term bonds that is full of changes to act as compensation in the event, there are losses that are incurred in the liquidity of an investment. Thus, the theory explains there are longer-term rates higher than the short-term rates. The last argument preferred habit theory explains the investors have a preferred maturity regarding their investments which matches their liabilities. Therefore, based on the assumption there is no need to assume the long-term investments will have higher returns compared to the short-term ones.
Indeed based on the term structure theories evidently are interested in the future interest rates for some reasons. First, the accuracy of prediction in the term structure is identified as it relatively easy to evaluate. Therefore, the investors when making investments can make it from an informed standpoint. Second, term structure theories are noted to explain in detail how the short-term interest changes rates affect the long-term interest rates. Moreover, it is evident monetary policy has a direct effect on the short-term rates. The theories provide information regarding the expectations of the participants in the financial markets where the expectations are of the considerable interests to the forecasts and the policy markets.
In summary, a question may be raised, which theory is best to explain interest rate determination? The Preferred Habitat Theory is recognized to be the most consistent theory that in detail explains day-to-day changes in the business term structure. However, when considerations are made regarding the long-run, it is evident the expectations of the future play a critical part in determining the future interest rates and liquidity premium and thus become essential components of the position and the ideal shape of the yield curve. Moreover, the government finds it very useful to study the term structure as they are helpful in implementing the monetary policies. With many of the theories dependant on the demand and supply of the products, it is paramount for the investors to define the best times to make their investments either in the short or long run.
Cox, J. C., Ingersoll Jr, J. E., & Ross, S. A. (2005). A theory of the term structure of interest rates. In Theory of Valuation (pp. 129-164).
Frenkel, J. A., & Johnson, H. G. (Eds.). (2013). The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.
Keynes, J. M. (2016). General theory of employment, interest and money. Atlantic Publishers & Dist.
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