What determines the difference between yields on long-term and short-term bonds?

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What determines the difference between yields on long-term and short-term bonds?



Answer: According to the EXPECTATIONS THEORY, bonds are priced so that the expected return over any period is independent of the maturity of the bonds held. Consequently, a higher yield on a longer-term bond implies that the investors expect future short-term interest rates to rise. However, the expectations theory ignores INTEREST RATE RISK, which arises from the fact that bond prices rise when market rates fall, and fall when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term bonds. According to the LIQUIDITY-PREFERENCE THEORY, long-term bonds earn extra return to compensate for interest rate risk, resulting in higher yields on long-term bonds and a tendency for the yield curve to be upward sloping.

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