Essay Sample on Marketing Structures and Theories

Introduction

The term structure of the interest rates is described as the calculated relationship between the productivity of different securities based on their maturity terms. A yield curve from the relationship is attained when graphed (Kung, 2015). The determinants of this relationship include the yield curve as well as the interest rates. From the analysis conducted by the economist and potential investors, it is believed that the yield curve shows the future interest rates expectations in the market and the existing monetary policy (Cieslak & Povala, 2016). This is possible through offering a completely scheduled interest rate over time. Using the term structure, it is possible to gather information about the future making it possible to make such predictions. Therefore, it is possible to know how different changes will impact the yield curve from the underlying variables (Joslin & Konchitchki, 2018).

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Main Theories of the Term Structure

The main theories that attempt to explain the term structure include the market segmentation theory, expectations theory, and the liquidity preference theory. The expectations theory of the term structure is used in regard to the expected future rates which is uses the present structure as the principal determinant of interest rates (Qin et al., 2018). It is based on some assumptions to explain the identified interest rates at that specific period. For instance, the potential investors are sure of the expected rates which they hold in high and complete confidence. On the expectation that the short-term rates will drop the present rates will increase above the long-term while the yield curve slopes to the negative side (Van Binsbergen & Koijen, 2017). Most importantly the expectation theory has perfect substitutes for the long and short term securities. Thus, investors could perfectly choose the investment they prefer to engage in because it is easy to predict the future. The theory has no changes in its yields even when the long-term securities decreases or increases. The policy impact of this theory is that replacing a certain amount of long-term liability with an equal amount of short-term liabilities will not affect the structure of interest rates.

The segmented market theory is also referred to as the institutional theory where the investors are most risk-averse. The investor will, therefore, match the maturity rates of their assets to the liabilities to make sure that the risks taken are equal to the assets they possess. In this case, the investor incurs capital losses when the maturity rate for their assets are longer compared to the rate related to the liabilities (Christensen & Rudebusch, 2017). This is because the investor is forced to sell off the assets before they are due to redeem them. In case the investor's maturity is shorter for the assets compared to the liabilities the result will be an income loss to the investor. To avoid such cases, the investors should be careful to create terms that match that of liabilities and their assets. Segmented market theory is based on some assumptions including the uncertainty on the behavior in the future about the interest rates and imperfect substitution of assets because of the differing maturity. In addition, the market for these assets has been group into different markets due to the different maturity.

Therefore, the theory determines both the long and short term interest rates from separated markets and this is then the segmented market due to the differing terms of the securities from the investors leading to the imperfect substitutes. The theory shows a yield curve representation of demand and supply of securities in the different maturities. In case, the supply of these securities is less than the demand in the market, the interest rate in short-term will be higher compared to the interest rate in the long run (Van Binsbergen & Koijen, 2017). On the other hand, the demand for securities lower than the supply in the interest rate in the short term will be lower compared to that in the long term. Therefore, it is clear to see that the market rates in this theory are dependent on the different terms as identified by the conditions of supply and demand. The monetary policy, in this case, implies that the government could successfully interfere with the long term and short interest rates when appropriate for either of them (Mallick et al., 2017). Furthermore, it would be possible for the central bank to influence the yields of the securities by allowing relative long-term and short-term. However, the implication is not possible if only supply is changed for short-term securities.

The liquidity theory is defined to be the variant of the Keynesian fluidity and expectation theory. The theory does not ascertain the view of securities in the long and short term because it cannot be compared to the differences in maturity (Del Negro et al., 2017). Therefore, the theory has embraced the yields obtained from different terms depending on the long or short term rates. Hence, there is a different attitude between the lender and borrower where each of the participants has different preferences. In this case, the lender like it when borrowers take short-term securities but borrowers will prefer the long-term based on their needs. This is because the long-term securities have a greater risk of placing the securities at a low expectation of liquidity in the future (Cecchetti and Schoenhholtz, 2017). The interest rates for long-term liabilities is higher compared to the interest rates for short term securities.

Conclusion

The term structure is used to define to show the yields of securities based on their maturities. The segmented theory is most supported for practices due to the emphasis on liquidity. On the other hand, the expectations theory does not advise its investors about the possible risks; rather they make their subjected prediction. Although the risk is neutral, there is no risk aversion in a case which could result in losses. The liquidity theory identifies the risks involved with the different maturities so that investors make informed decisions and an improvement of the other theories.

References

Cecchetti, S. and Schoenhholtz, K. (2017) Money, Banking and Financial Markets (5th ed). McGraw-Hill Irwin .https://s3.amazonaws.com/academia.edu.documents/44706729/_CORE_-_2nd_SEMESTER___Money__Banking_and_Financial_Markets_-_Cecchetti.pdf?AWSAccessKeyId=AKIAIWOWYYGZ2Y53UL3A&Expires=1550851237&Signature=jBZKPD2Ew5vM9wbkGeeGfBFHCZE%3D&response-content-disposition=inline%3B%20filename%3DCORE_2nd_SEMESTER_Money_Banking_and_Fin.pdf

Christensen, J. H., & Rudebusch, G. D. (2017). New evidence for a lower new normal in interest rates. FRBSF Economic Letter, 17. https://www.frbsf.org/economic-research/files/el2017-17.pdf

Cieslak, A., & Povala, P. (2016). Information in the term structure of yield curve volatility. The Journal of Finance, 71(3), 1393-1436. https://onlinelibrary.wiley.com/doi/abs/10.1111/jofi.12388

Del Negro, M., Giannone, D., Giannoni, M. P., & Tambalotti, A. (2017). Safety, liquidity, and the natural rate of interest. Brookings Papers on Economic Activity, 2017(1), 235-316. https://muse.jhu.edu/article/671750/summary

Joslin, S., & Konchitchki, Y. (2018). Interest rate volatility, the yield curve, and the macroeconomy. Journal of Financial Economics, 128(2), 344-362. https://www.sciencedirect.com/science/article/pii/S0304405X17303148

Kung, H. (2015). Macroeconomic linkages between monetary policy and the term structure of interest rates. Journal of Financial Economics, 115(1), 42-57. http://www.microeconomicsnotes.com/economic-theories/theory-of-interest/term-structure-of-interest-rates-meaning-factors-and-theories/1390

Mallick, S., Mohanty, M. S., & Zampolli, F. (2017). Market volatility, monetary policy and the term premium. https://financetrain.com/theories-of-the-term-structure-of-interest-rates/

Qin, L., Linetsky, V., & Nie, Y. (2018). Long forward probabilities, recovery, and the term structure of bond risk premiums. The Review of Financial Studies, 31(12), 4863-4883. https://academic.oup.com/rfs/article-abstract/31/12/4863/4962623

Van Binsbergen, J. H., & Koijen, R. S. (2017). The term structure of returns: Facts and theory. Journal of Financial Economics, 124(1), 1-21.https://ebrary.net/14275/economics/classic_theories_term_structure_interest_rates