THEORY OF INTEREST RATE TERM STRUCTURE

Interest rate term structure is a function relating interest rate to term of maturity. Interest rate term structure is related to the idea of yield curve. Yield curve is a plot of interest rate yields on bill or bond with differing terms to maturity but with the same risk. The relationship between short and long interest rates and shape of yield curve are both explained by the following theories: expectations hypothesis and market segmentation hypothesis. The expectation hypothesis is not a homogenous theory and has several types. The expectations hypothesis can be divided into the pure expectations theory and weight expectations theory. The weight expectations theory can be divided into liquidity theory and preferred habitat theory. The paper gives a summary of individual theories concerning interest rate term structure discussing and comparing them briefly