Basics of Corporate Finance

To illustrate the expectations...

To illustrate the expectations theory, suppose that inflation is expected to be 4% this coming year, 6% in the year following, and 8% in the third year. The inflation premium (average expected yearly inflation) will be 4% for the first year, 5% for the second year, and 6% for the third year. If the real, risk-free rate is 3%, then the resulting Treasury Bill interest rates (risk-free rate plus inflation premium) will be 7% for a one-year T-bill, 8% for a two-year T-Bill, and 9% for a three-year T-bill. A change in these expectations will cause a shift in the yield curve for the T-Bills.

  1st yr 2nd yr 3rd yr
Expected inflation 4% 6% 8%
Average inflation premium 4% 5% 6%
+ Real risk-free interest rate 3% 3% 3%
= T-bill interest rate 7% 8% 9%

2. Market Segmentation Theory

Each lender and each borrower has a preferred maturity. Some lend / borrow for long-term needs and others lend / borrow for short-term needs. The market segmentation theory states that the slope of the yield curve depends on supply / demand conditions in the short-term and long-term markets.

An upward sloping curve results from a large supply of funds in the short-term market relative to demand and a shortage of long-term funds. A downward sloping curve indicates strong demand in the short-term market relative to the long-term market. A fairly horizontal yield curve indicates that supply and demand for funds is roughly balanced both in the short- term and long-term markets.