Principles of Managerial Finance

FIGURE 6.3

Treasury Yield Curves
Yield curves for U.S. Treasury
securities: May 22, 1981;
September 29, 1989; and
March 15, 2002

268 PART 2 Important Financial Concepts

The shape of the yield curve may affect the firm’s financing decisions. A

financial manager who faces a downward-sloping yield curve is likely to rely more

heavily on cheaper, long-term financing; when the yield curve is upward-sloping,

the manager is more likely to use cheaper, short-term financing. Although a vari-

ety of other factors also influence the choice of loan maturity, the shape of the

yield curve provides useful insights into future interest rate expectations.

Theories of Term Structure

Three theories are frequently cited to explain the general shape of the yield curve.

They are the expectations theory, liquidity preference theory, and market seg-

mentation theory.

Expectations Theory One theory of the term structure of interest rates, the

expectations theory,suggests that the yield curve reflects investor expectations

about future interest rates and inflation. Higher future rates of expected inflation

will result in higher long-term interest rates; the opposite occurs with lower

future rates. This widely accepted explanation of the term structure can be

applied to the securities of any issuer. For example, take the case of U.S.

Treasury securities. Thus far, we have concerned ourselves solely with the 3-

month Treasury bill. In fact, all Treasury securities arerisklessin terms of (1) the

chance that the Treasury will default on the issue and (2) the ease with which

they can be liquidated for cash without losing value. Because it is believed to be

easier to forecast inflation over shorter periods of time, the shorter-term 3-month

U.S. Treasury bill is considered the risk-free asset. Of course, differing inflation

expectations associated with different maturities will cause nominal interest rates

to vary. With the addition of a maturity subscript,t,Equation 6.3 can be rewrit-

ten as

RF

t

k*IPt (6.4)

18

16

14

12

10

8

6

4

2

5

0

10 15 20 25 30

Yield (annual rate of interest, %)

Time of Maturity (years)

May 22, 1981

September 29, 1989

March 15, 2002

Data from Federal Reserve Bulletins (June 1981), p. A25 and (December 1989), p. A24;

and U.S. Financial Data, Federal Reserve Bank of St. Louis (March 14, 2002), p. 7.

Sources:

expectations theory
The theory that the yield curve
reflects investor expectations
about future interest rates; an
increasing inflation expectation
results in an upward-sloping
yield curve, and a decreasing
inflation expectation results in a
downward-sloping yield curve