Several theories have been used to explain the shape of the yield curve. Three major theories are:
(a) Market segmentation theory
(b) Liquidity preference theory
(c) Expectation theory
(a) The Market Segmentation Theory
This theory states that each lender and each borrower has a preferred maturity. For example a company borrowing to buy long term assets like plant and equipment would want to borrow in the long-term market. However, a retailer borrowing to build the level of inventories in anticipation for increased sale would borrow in the short term market. Similarly differences exist among lenders (or savers). For example a person saving to pay school fees next term would lend in the short-term market while one saving for retirement twenty years hence would save in the long-term market.
The market segmentation theory states that there exist two separate markets the short term and long term markets. The slope of the yield curve depends on the demand and supply conditions in both markets. An upward sloping curve would occur when there is a large supply of funds relative to demand in the short term market but a relative shortage of funds in the long term market. Similarly a downward sloping curve would indicate relatively strong demand in the short term market compared to long term market while a flat curve would indicate balanced demand in the two markets.
(b) Liquidity Preference Theory
This theory states that long term bonds normally yield more than short term bonds for two reason:
i. Investors generally prefer to hold short-term securities because such securities are more liquid since they can be converted to cash with little danger of loss of principal. Hence other things being constant investors will accept lower yields on short term securities.
ii. At the same time borrowers react in the opposite way. Generally, they prefer long-term debt to short-term debt because short term debt expose them to the risk of having to repay the debt under adverse conditions. Accordingly borrowers are willing to pay a higher rate, other things remaining constant, on long-term funds than short term funds. Taken together, these two sets of preferences imply that under normal conditions a true maturity risk premium exist which increases with increase in maturity and thus the yield curve is upward sloping.
(c) Expectations Theory
This theory states that the yield curve depends on expectations about factors affecting future expected returns on similar assets. Examples of such factors include economic conditions such as inflation, recession and boom or political conditions. Taking inflation as an example: If the annual rate of inflation is expected to decline, the yield curve will be downward sloping whereas it will be upward sloping if the inflation rate is expected to increase.
Other factors influencing interest rates are:
i. Central bank monetary policy
ii. Government fiscal policy
iii. The level of business activities etc.