The term structure of interest rates is the relationship between yield to maturity and time to maturity. A graph with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis is called the yield curve.

a. Any theory of the term structure of interest rates must explain three facts:

i. Interest rates of different maturities move together.

ii. The yields on short-term bonds are more volatile than the yields on long term bonds.

iii. Long-term yields are usually higher than short-term yields.

b. The expectations hypothesis of the term structure of interest rates states that long term interest rates are the average of expected future short-term interest rates. This hypothesis explains only the first two facts about the term structure of interest rates.

c. The liquidity premium theory of the term structure of interest rates, which is based on the fact that long-term bonds are riskier than short-term bonds, explains all three facts in part a.