Even though most of us may not realized it, interest rate actually play an important role in our everyday lives due to its great effect on the buying power. For instances, if the interest rate is higher, people tend to reduce their spending and rather save it in the deposit account due to the large interest that they can gained. However, if the interest rate is lower, they rather spend it than keeping it in the deposit account. The reason for this is because the ups and down of the interest rates have a significant impact on their personal income. Furthermore, since interest rate have a major impact on investment it is important for the investors to keep track on these interest rate’s trend ...view middle of the document...
However, there are also some investor that choose to invest in long-term security when there is inverted yield curve. This is due the fact that they interpret the inverted yield curve as an indication that the recession will happen in the future. Hence, they want to lock in long-term securities with the current higher yield.
3) Flat yield curve – It is a yield curve in which that there is a little different between short-term and long-term rates. These curves indicate that the market environment may be showing mixed signals to investors that the short-term interest rates will rise and some other signal showing that long-term interest rate will fall. This pattern usually occurred when there is a transition between normal and inverted curves thus creating a flatter curve than its normal yield curve.
There are also three theories that can explained the relationship between the maturities and interest rates of securities and also the shapes of yield curves. There are pure expectation theory, market segmentation theory and liquidity premium theory. With these theories, it should explain three important empirical facts that shaped the yield curves, which are:
• Interest rate on securities of different maturities move together over time
• When short-term rates are low, yield curve more likely to have upward slopes; when long-term rates are high, yield curve more likely to have downward slopes.
• Yield curves almost always upward sloped
These theories will be discussed in detail below:
1. Pure expectation theory – It is the market prediction of future interest rate that usually...