Three theories used to describe the shape of the yield curve
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Compare and contrast the three theories used to describe the shape of the yield curve. Explain how each theory might impact interest rates.
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Solution Summary
This post compares the three theories of the yield curve to understand how the interest rates behave over a period of time in simple text. (Approx. 405 words).
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The three theories are:
1: Market expectations theory: This theory suggests that the shape of the yield curve is based on market participants' expectations of future interest rates. These expected rates, along with an assumption that arbitrage opportunities will be minimal, is enough information to construct a complete yield curve. For example, if investors have an expectation of what 1-year interest rates will be next year, the 2-year interest rate can be calculated as the compounding of this year's interest rate by next year's interest rate. More generally, rates on a long-term instrument are equal to the geometric mean of the yield on a series ...
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