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Hello students, here is a question.
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Discuss two theories of a term structure of interest rate, including your discussion, the difference between the theories and the advantages disadvantages of the theory.
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So, this is our question.
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Let us discuss the answer for this.
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The term structure of interest rates refers to the relationship between interest rate of bond.
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The first is relationship between interest rate of bond with different maturities.
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There are two main theories to explain this relationship, the expectation theory and the liquidity preference theory, expectation theory and liquidity preference theory.
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These two theory we are going to explain here.
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The expectation theory suggests that shape of a yield curve is determined by the market expectation of future interest rate.
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According to this theory, the long -term interest rate are simply the average of expected future short -term interest rate.
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For example, a investor expects a short -term interest rate for the future, the long -term interest rate will rise reflect on the expectation.
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The main advantages of this theory is based on the rational behavior of a market participants and their expectations...