Assume that interest rates on federal government bonds are as follows:

1-year = 6.5%

2-year = 6.3%

3-year = 6.0%

4-year = 5.8%

5-year = 5.5%

10-year = 5.2%

15-year = 5.0%

20-year = 5.0%

Do the theories of the shape of the yield curve offer any insights into this rate pattern? Discuss the expectations, liquidity preference, and market segmentation theories separately.

Answer (a) :

In the above data, Yield curve shape will be inverted (negative), Which indicate that short term yields are more than long term yields.

Answer (b)

Expectations theory : As per expectation theory investor can earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. It deal in short term interest rate.

Liquidity preference theory : this theory is also called demand for money. As per this theory Interest is not reward of hold the money. Every person keen to hlod the money in such assets where assets convert in money rapidly to meet unexpected expenditure.

Market Segmentation : According to market segmentation theory, It is not necessary there a relationship exists between short term and long term interest rate.