Financial Management · Causes of exchange rate differences and interest rate fluctuations

Causes of Interest Rate Fluctuations and the Yield Curve

Updated 11 October 2026 · Fact-checked

Interest rates change because of central bank policy, inflation, credit risk and the supply and demand for funds. The yield curve plots yield against time to maturity. Expectations theory, liquidity preference and market segmentation explain its shape. In the exam, name the shape, then match it to the right theory.

Understand Causes of Interest Rate Fluctuations and the Yield Curve

An interest rate is the price of borrowing money. Like any price, it moves with supply and demand. If lenders have more funds than borrowers want, rates fall. If borrowers want more than lenders offer, rates rise.

Several factors push rates around. The central bank sets a base rate, which feeds into bank lending and deposit rates. Higher expected inflation raises rates because lenders want a real return. Government borrowing can raise rates by competing for funds. Risk matters too: a borrower with a higher default risk pays a higher rate. So does a longer loan, because the lender is exposed for longer.

The yield curve shows the yield on bonds of the same issuer type and credit risk at different maturities. It is also called the term structure of interest rates. A normal curve slopes upwards: long-term yields are higher than short-term. An inverted curve slopes downwards: short-term yields are higher. A flat curve shows similar yields at all maturities. Be precise about what is held constant: same risk, different time to maturity.

Three theories explain the shape. Expectations theory says long-term rates are an average of expected future short-term rates. If the market expects rates to rise, the curve slopes up. If it expects rates to fall, the curve inverts. Liquidity preference theory says investors want a premium for locking money away, because long-term bonds are less liquid and their prices are more volatile. So long-term yields include a liquidity premium and the curve tends to slope upwards even if rates are expected to stay flat. Market segmentation theory says the market is split into separate groups, for example banks that prefer short-term and pension funds that prefer long-term. Each segment has its own supply and demand, so each maturity has its own rate, and the curve's shape can be irregular.

The theories are not rivals in practice. Real curves reflect a mix of expectations, a liquidity premium and segment demand. For a company, the curve helps decide whether to borrow short or long and signals what the market expects for future rates.

Key rules to remember

Long-term rate under pure expectations: (1 + r₂)² = (1 + r₁) × (1 + f); r₁ is the one-year spot rate, r₂ is the two-year spot rate and f is the expected one-year rate in a year's time. Rearrange to find f.
Implied forward rate: f = (1 + r₂)² ÷ (1 + r₁) − 1; This is the rate the market expects for year 2 under pure expectations theory. It is a general method, not always given in the FM exam, so check the question.
Liquidity preference: Long-term yield = expected average short-term rate + liquidity premium; The premium normally increases with maturity. This is a conceptual rule, not a calculation you will usually be given numbers for.
Components of a nominal rate: Nominal rate ≈ real rate + expected inflation + risk premium; A simple way to list causes of rate differences. It is an approximation.

How to solve Causes of Interest Rate Fluctuations and the Yield Curve questions

Use this method for any question on why rates change or what a yield curve shows.

1Read what is asked: causes of rate changes, the meaning of a curve shape, or a choice between theories.
2If a curve or set of yields is given, state its shape: upward, inverted or flat. Check that the yields are for the same risk class.
3Link the shape to the theory asked for. Upward: expectations of rising rates and/or a liquidity premium. Inverted: expectations of falling rates. Irregular: market segmentation.
4If a calculation is asked for, compute the implied forward rate using (1 + r₂)² = (1 + r₁)(1 + f). Work in decimals and check the answer is reasonable.
5Add other causes where relevant: central bank policy, inflation, government borrowing, credit risk and the supply and demand for funds.
6Apply to the business: say what the curve suggests for the choice between short-term and long-term borrowing or for expected rate movements.
7For written parts, make one clear point per mark and tie each to the scenario.

Quickest way: Shape, theory, implication

When to use it: Use this for objective test questions where you must pick the theory or interpretation quickly.

Name the shape in a few seconds: upward, inverted or flat.
Ask the key wording: does the question mention expected future rates, a premium for tying up money, or separate groups of investors?
Expected rates or forecasts: expectations theory. Premium for risk or reduced liquidity: liquidity preference. Separate lenders and borrowers by maturity: market segmentation.
If a forward rate is needed, use f = (1 + r₂)² ÷ (1 + r₁) − 1 and check by recomputing.
Eliminate options that overstate, such as saying a curve always slopes up.

Common mistakes in Causes of Interest Rate Fluctuations and the Yield Curve

Saying an upward-sloping curve proves the market expects rates to rise.
Students learn expectations theory and forget the liquidity premium.
Fix: Say the slope may reflect expected rises, a liquidity premium, or both. Only pure expectations theory gives the first reading alone.
Mixing up liquidity preference and market segmentation.
Both mention investor preferences for maturity.
Fix: Liquidity preference: investors want extra yield for longer lending, so one connected curve with a premium. Market segmentation: separate markets with their own supply and demand.
Comparing yields on bonds of different credit quality as a yield curve.
Students ignore that the curve holds risk constant.
Fix: State that the curve compares the same issuer or risk class at different maturities. Differences across risk classes are credit spreads.
Using the two-year rate as the year-2 forward rate.
The two-year spot rate is an annual average over both years, not the rate for year 2 alone.
Fix: Use (1 + r₂)² = (1 + r₁)(1 + f) and solve for f.
Listing only central bank policy as a cause of rate changes.
Monetary policy is the most familiar cause.
Fix: Also give inflation, government borrowing, risk, term and general supply and demand for funds.
Writing everything in general terms without applying it to the scenario.
Students recall theory but skip the business implication.
Fix: End each point with what it means for the company, such as a choice of fixed or floating or short or long borrowing.

Worked examples

Example 1

The one-year spot rate is 4% and the two-year spot rate is 5%, for bonds of the same risk. Using pure expectations theory, calculate the expected one-year rate in one year's time, and comment on the curve.

Show the solution

Use (1 + r₂)² = (1 + r₁)(1 + f).
(1.05)² = 1.1025.
1.1025 ÷ 1.04 = 1.06010 (to five decimal places).
f = 1.06010 − 1 = 6.01% (to two decimal places).
The curve slopes upwards. Under pure expectations theory, this means the market expects short-term rates to rise from 4% to about 6.01%.
Under liquidity preference, part of the upward slope could instead be a premium for the longer maturity, so the expected rise may be smaller.

Answer: The expected one-year rate in one year is about 6.01%. The upward slope signals expected rising rates under expectations theory, though a liquidity premium may explain part of it.

Example 2

A company needs to borrow for five years. Short-term yields are currently 6% and long-term yields are 4.5%, for the same risk class. Explain what the curve shape suggests and how the finance director should use it.

Show the solution

The curve is inverted: short-term yields exceed long-term yields.
Under expectations theory, the market expects short-term rates to fall over time, so the average of expected future short rates is lower than today's rate.
An inverted curve is hard to explain with a liquidity premium alone, because the premium would push long yields up. So expected falls in rates must outweigh any premium.
Under market segmentation, heavy demand from long-term investors such as pension funds could also push long-term yields down.
For the company, long-term borrowing is cheaper now at 4.5%. Fixing for five years locks in a lower rate, but if rates do fall as expected, it may later pay more than the market rate.
The director should weigh the lower cost now against flexibility, any early repayment terms and the company's own rate forecast.

Answer: The inverted curve suggests the market expects falling short-term rates, possibly reinforced by segment demand. Long-term fixed borrowing at 4.5% is cheaper today but may be above future market rates, so the director should weigh cost against flexibility.

Exam tips

In objective questions, key words decide the theory: expectations of future rates points to expectations theory, a premium for illiquidity points to liquidity preference, separate investor groups point to market segmentation.
Always describe the curve shape first. Written answers lose marks when the shape is not stated.
Show the forward rate working in full. Compute (1 + r₂)² first and then divide by (1 + r₁).
In Section C written parts, give several distinct causes of rate changes and link each to the scenario company.
Avoid absolute statements such as an inverted curve always means recession. Say it can signal expected falls in rates.

Practice questions from Causes of exchange rate differences and interest rate fluctuations

Causes of Interest Rate Fluctuations and the Yield Curve in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

NISM CertificationsYield Curve and Term Structure of Interest Rates

Causes of Interest Rate Fluctuations and the Yield Curve: frequently asked questions

Why are long-term interest rates usually higher than short-term rates?

Lenders face more risk and less liquidity when they lend for longer, and long-term bond prices are more volatile. Liquidity preference theory says they demand a premium for this. The market may also expect rates to rise.

What is the difference between liquidity preference and expectations theory?

Expectations theory says the curve shape comes only from expected future short-term rates. Liquidity preference adds a premium for longer maturities, so the curve tends to slope upwards even if rates are expected to be stable.

What does an inverted yield curve mean?

Short-term yields are higher than long-term yields. It usually indicates that the market expects short-term rates to fall. It is a signal, not a guarantee of any outcome.

What is market segmentation theory?

It says the market is divided into groups with preferred maturities, such as banks for short-term and pension funds for long-term. Each segment sets its own rate through its own supply and demand, so the curve can take irregular shapes.