In late April 1980, the Treasury had to pay a higher rate for three-month funds, 12.18 percent, than for one-year funds, 10.80 percent. However, by the end of June of the same year, not only had the general level of interest rates come down, but the relationship between three-month and one-year rates for the Treasury had reversed. In June, the Treasury had to pay a higher rate for one-year funds, 7.30 percent, than for three-month funds, 6.77 percent.
Other borrowers in the forex market probably had to pay a rate higher than the Treasury, but the relationship between the cost of funds for three months and one year for these other borrowers was similar to that for the Treasury in each of the dates in the exhibit.
Market Expectations
The market's expectations for changes in the overall level of interest rates are independent of the borrower. That is why other borrowers, besides the Treasury, were exposed to similar relationships between the cost of funds for longer and shorter maturities. And it is the forex trading trading market's expectations for future rates that determines this relationship. At the end of April 1980, the market was expecting future levels of interest rates to decline. However, by the end of June 1980, the market was expecting interest rates to increase in the future.
If the interest rates are generally expected to be lower in the future than they are today, the situation prevailing at the end of April 1980, investors and borrowers will have the following preferences: Investors would prefer to place funds in the longer maturities to lock in the current higher interest rate. Borrowers would prefer to borrow funds for shorter maturities so they can refinance at the expected future lower rates. So, in the very short maturities, Supply of funds demand for funds While in the longer maturities, Supply of funds demand for funds So for short maturities interest rates will tend to increase, while interest rates will tend to decrease in longer maturities, as in Exhibit 7.2. The result is a downward-sloping yield curve, as at the end of April 1980. On the other hand, if interest rates are generally expected to be higher in the future than they are today, the situation prevailing at the end of June 1980, investors and borrowers will have the following preferences: Investors would prefer to place funds in the shorter maturities so they can reinvest their funds at the expected future higher rates. Borrowers would prefer to borrow funds for longer maturities so they can lock in the current lower interest rate. So, in the very short maturities, Supply of funds demand for funds While in the longer maturities, Supply of funds demand for funds As a result, interest rates will tend to decrease for short maturities, while interest rates will tend to increase for longer maturities, as in Exhibit 7.3. This will produce an upward-sloping yield curve. as at the end of June 1980.3 In summary. the shape of a yield curve reflects the market's expectations for future developments in interest rates. An upward-sloping yield curve shows that the market expects future short-term interest rates to be higher than they are today. A downward-sloping yield curve. on the other hand, shows that the market expects future short-term interest rates to be lower than they are today.
Other Factors
It is generally believed that even if market expectations call for future interest rates to remain at today's level, the yield curve would not be flat, but upward-sloping. This is because the market demands a premium be paid for lending for longer maturities, in contrast to shorter ones. There are three major reasons for this premium to exist: The longer the maturity of a loan, the higher the uncertainty as to the ability of the borrower to repay the debt-the higher the credit risk. If a loan or any other investment has to be liquidated before maturity, it is generally easier to liquidate shorter-maturity paper than longer-maturity paper at the going market rates longer maturities tend to have a higher liquidity risk.
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