Term structure of interest ratesInterest rates are a factor of the current rate, expected inflation and future interest rates. There are three main theories attempting to explain how interest rates vary with time.
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2 Liquidity Preference Theory
3 Market Segmentation Theory
Market Expectations (Pure Expectations) Theory
Interest rates are quoted according to the associated time periods. A CD (Certificate of Deposit) for 2 years will pay a different rate than a CD for 1 year. The Market Expectations theory states that a CD for 2 years will pay the same interest rate as a CD for 1 year followed by another CD for 1 year.
Liquidity Preference Theory
This theory states that borrowers pay an incentive to lenders in order to obtain funds for a longer duration. This explains why interest rates for longer time periods are often higher than those for shorter time periods.