© 2000 John Petroff
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© 2000 John Petroff |
In general, the longer lender's money must be tied up in a given financial asset the higher this component of interest rate will be (irrespective of risk or inflation). The normal pattern of increasingly higher returns on longer maturities is known as the structure of interest rates or yield curve (and it is also known as term structure). Thus, in normal times, the longer the maturity, the higher the interest rate. The normal moderately upsloping yield curve is explained by increasing illiquidity aversion in longer maturities, as well as cumulative anticipated inflation. Graph G-2.1 presents a yield curve of US municipal bond yield on April 16, 2000 based on values published by Standard & Poor on their web site www.s&p.com.
When accelerating inflation is predicted (for instance, because of a rapidly expanding economy), the yield curve becomes steeply upsloping. Long-term securities are expected to decrease in value as interest rates rise. Then, it makes no sense holding long term maturities: everyone jumps on the bandwagon selling long term maturity issues. This causes their price to drop and their rate of return to rise. On the contrary, when disinflation (i.e. decreasing inflation) is expected, long term securities are expected to increase in value as rates go down. Since short term bonds do not offer such opportunity of appreciation, investors shift into long term bonds to take advantage of the expected price rise. This added demand for long term bonds pushes their price higher and their rate of return lower. Disinflation causes the yield curve to have an unusual downsloping shape. Explanation of the rates structure is known as segmentation of markets.
| In 1995, Russia experienced an upsloping yield curve. As noted earlier, in reality, there are very few ruble loans that are beyond a year in maturity. Meanwhile, in the United States in 1995, the yield curve was steeply upsloping (in a J shape) because of the economic expansion and the expectation of a pick up in inflation. The yield curves of Switzerland and Germany were downsloping in 1994 suggesting even lower inflation in the future. |
See review questions Q-2D4.1 through Q-2D4.5.
See research assignment R-D4.1.
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