Although as well see other theories exist the

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: ping yield curve; and a stable inflation expectation results in a flat yield curve. Although, as we’ll see, other theories exist, the observed strong relationship between inflation and interest rates (see Figure 6.2) supports this widely accepted theory. liquidity preference theory Theory suggesting that for any given issuer, long-term interest rates tend to be higher than short-term rates because (1) lower liquidity and higher responsiveness to general interest rate movements of longer-term securities exists and (2) borrower willingness to pay a higher rate for long-term financing; causes the yield curve to be upward-sloping. market segmentation theory Theory suggesting that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each segment. Liquidity Preference Theory The tendency for yield curves to be upwardsloping can be further explained by liquidity preference theory. This theory holds that for a given issuer, such as the U.S. Treasury, long-term rates tend to be higher than short-term rates. This belief is based on two behavioral facts: 1. Investors perceive less risk in short-term securities than in longer-term securities and are therefore willing to accept lower yields on them. The reason is that shorter-term securities are more liquid and less responsive to general interest rate movements.7 2. Borrowers are generally willing to pay a higher rate for long-term than for short-term financing. By locking in funds for a longer period of time, they can eliminate the potential adverse consequences of having to roll over shortterm debt at unknown costs to obtain long-term financing. Investors (lenders) tend to require a premium for tying up funds for longer periods, whereas borrowers are generally willing to pay a premium to obtain longer-term financing. These pref...
View Full Document

This document was uploaded on 01/19/2014.

Ask a homework question - tutors are online