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The term structure of interest rates is the variation of the yield of bonds with similar risk profiles with the terms of those bonds. The yield curve is the relationship of the yield to maturity (YTM) of bonds to the time to maturity, or more accurately, to duration, which is sometimes referred to as the effective maturity. In most cases, bonds with longer maturities have higher yields. However, sometimes the yield curve becomes inverted, with short-term notes and bonds having higher yields than long-term bonds. Sometimes, the yield curve may even be flat, where the yield is the same regardless of the maturity. The actual shape of the yield curve depends on economic conditions, fiscal policies, expected forward rates, inflation, foreign exchange rates, foreign capital inflows and outflows, credit ratings of the bonds, tax policies, and the current state of the economy. The term structure of interest rates has 3 characteristics:

1. The change in yields of different term bonds tends to move in the same direction.

2. The yields on short-term bonds are more volatile than long-term bonds.

3. The yields on long-term bonds tend to be higher than short-term bonds.

The expectations hypothesis has been advanced to explain the 1st 2 characteristics and the premium liquidity theory have been advanced to explain the last characteristic. The market segmentation theory explains the yield curve in terms of supply and demand within the individual segments.

Market Segmentation Theory

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