In ACCA FM/AFM exam, 1 of challenging areas is risk management.
Risk management is divided into foreign exchange rate and interest rate risk management.
In this concise technical article, I share with you the causes of interest rate fluctuations theories, including -
Term structure of interest rates or yield curves;
Pure expectation theory;
Liquidity premium theory; and
Market segmentation theory.
In addition, example is extracted from ACCA F9 past exam paper to explain how the theories can be applied to come up a correct answer.
The following discussion about yield curves and related theories is in Question & Answer format which is considered more easy for you to follow.
Yield Curve Theories
1. What is yield curve?
Answer: Yield curve refers to the relationship between the interest rates (redemption yield) and the terms to maturity, it is also known as Term Structure of Interest Rates.
2. What is a normal yield curve look liked?
Answer: A normal yield curve is usually upward sloping, i.e., the longer the terms to maturity, the higher is the yield.
3. Is there any theory explaining yield curve?
Answer: Yes. There are 3 theories behind yield curve, namely, Pure Expectation Theory, Liquidity Premium Theory and Market Segmentation Theory.
Other Theories Explaining Interest Rate Fluctuations
4. What is Pure Expectation Theory? And how it relates to yield curve?
Answer: This theory based solely on investors' expectation on future interest rates. If investors expect that interest rates will rise (fall) in the future, yield curve will be upward (downward) sloping.
5. What is Liquidity Premium Theory? How does it relate to yield curve?
Answer: Investors must be compensated for tying up their money for a longer period of time, thus a higher rate of interest must be paid on longer maturity bonds.
6. What is Market Segmentation Theory? How does it relate to yield curve?
Answer: This theory suggests that interest rates depended entirely on the demand and supply at a particular segment (terms to maturity) of the market.
Downward Sloping Yield Curves
7. Why is yield curve sometimes downward sloping?
Answer: In general, liquidity premium theory prevails and dominates the shape of yield curve.It means longer maturity will have higher yield to depositors in order to compensate for tying up their money.
However, when there is a strong party requires higher yield for short term funds and it pushes up short term rate to even higher than long term rate.
The yield curve is an average reflecting the financial market, and “kinks” will exist where one type of investor becomes more significant than another.
Illustration
In the latest syllabus, risk management (both foreign exchange rate and interest rate) questions are mainly in Section A (Objective Test Questions) and Section B (Case Based Objective Test Questions).
The past paper question shared here is from Section A of December 2014.
Let's read the question below -
Here is the explanation for each option in this question.
Option A is about monetary policy. If interest rates are decided to be up, it is known as contraction or tightening monetary policy.
General expenditure in the economy under tightening monetary policy will be decreased.
So, option A is not correct.
Option B explains the normal yield curve. It is upward sloping so longer maturity implies higher yield to compensate the liquidity lost.
In other words, higher yield in longer maturity compensates investors for being unable to use cash now.
Hence, option B is correct.
Option C tries to explain the inverted yield curve.
When there is a strong party requires higher yield for short term funds and it pushes up short term rate to even higher than long term rate, then, inverted yield curve appears.
It is not relevant to long term debt is less risky than short term debt.
It is mainly due to short term liquidity is tightened and a group of people needs to pay higher yield for short term funds.
Therefore, option C is not correct.
Option D is about expectation theory. We know that it is people's expectations on future interest rates.
If investors expect that interest rates will rise (fall) in the future, yield curve will be upward (downward) sloping.
Expectation theory is about the yield curve is upward or downward sloping, but not the future inflation rate movements.
In other words, option D is not correct.
Conclusion
Yield curve theories are explaining the causes of interest rate fluctuations while we have -
Term structure of interest rate or yield curves;
Pure expectation theory;
Liquidity premium theory; and
Market segmentation theory.
In our illustration, we clearly explain how to derive the answer based on what you learnt above.
Try to go to our Practice Questions or Mock Exam to test your knowledge on this area.
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