Commercial Metals Company (CMC) is a corporation that deals in metals. The corporation has expanded to other business ventures such as the hotel industry and in software design. CMC has recently predicted changes in the economy. Change in the economy reveals itself through interest rates, unemployment rates as well as retail trends. Various interest theories have been developed and are known to produce certain yield curves which also determine the term structure of various interest rates, which are then used to make certain predictions into the future of a company by financial analysts. This paper will discuss and compare the liquidity theory, expectations theory, market segmentation theory as well as the preferred habitat hypothesis theory. It will also demonstrate how these theories are used to explain changes in the economy with the use of examples.
When one borrows a loan, he/she pays the borrowed amount with an extra to amount on top of it. This extra amount is referred to as interest and it varies from one lender to another, depending on their interest rates. A retail sale is the amount of goods consumed by the population. Unemployment is determined by the average earnings of the general public. These three terms are intertwined and a shift in one causes a shift in the other. An increase in unemployment causes a rise in the interest rates while strong retail trends cause a rise in interest rates too . Interest rates play a major role in determining the future financial status of a company in order to maximize their returns. Corporations ought to borrow when interest rates are low and lend when the interest rates are high. Various theories are applied in order to determine the rate of interest. These include the liquidity theory, the market segmentation theory, the preferred expectations theory and the expectations theory.
A yield curve shows different earnings that can result from different contracts duration. This gives an indicator for investors on the duration of contracts they should get into, whether long term or short term. These yield curves are derived from the various interest determination theories . The expectation theory dictates that there is a consistency in the interest rates despite the maturity rates in consideration. It stipulates that the interest rates are determined by the expectations of the various participants. Expectations theory is based on the hypothesis that interest rates projected for the long run forecast upcoming short term interest rates correctly. It produces a consistent yield curve but fails to explain this consistency. The market segmentation theory stipulates that all yields correspond to each other. Changes in other factors in the economy result to changes in the interest rates. As a result, it advises on short terms for liquid and long terms for assets. It also dictates that short terms have fewer yields as compared to long terms. The preferred habitat theory produces a normal yield curve that expects shifts in the economy to cause changes in the interest rates. However this theory also acknowledges that certain abnormalities in the economy can cause an abnormal yield curve. The liquidity theory expects short terms to have fewer yields, while long terms have higher yields. This theory associates long terms with increased risks and therefore compensates investors for taking this risk.
The expectation theory is different from all the other theories. This theory expects a certain consistency in the interest rates despite the varied terms whether long or simply short term. However this theory fails to explain this consistency . The market segmentation theory, just like the liquidity theory, expects short terms to have fewer yields. However the liquidity theory acknowledges the risk that comes with long term investments and goes on to compensate investors for this risk. The preferred theory expects the yield curve to shift in correspondence to shifts in the economy. Normally, it expects that short terms have fewer yields but due to its reliance on other players in the economy, sometimes this can change causing short terms to have higher yields and vice versa.
In conclusion, interest determination is critical in the world of business. Interest rates, unemployment and retail trends influence the economy. Proper prediction of the economy and proper application of the interest determination theories are applied to produce the yield curves. The yield curves give an insight into the amount of the returns from their investment over different periods. These yield curves also assist both borrowers as well as lenders to make better decisions on when it is most profitable to borrow and lend money. These factors are critical for any corporation’s financial analysis. For a company to be most profitable, it should be able to predict into the future of the economy, and make reliable predictions. These predictions are then displayed using the yield curve and the term structure, which are then used to predict the economy. An insight into the economy enables a company to make the most profitable investments; to borrow or lend, short term investments or long term investments.
References
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