The 'Embodied Equity' Theory of Term Structure

Abstract

This study analytically specifies the residual cash flow stream that real capital embodies. The specification separates debt cash flows from equity and obtains an equilibrium condition equating marginal physical product and real user cost of capital. Analysis of the user cost specification reveals that the equilibrium interest rate is an increasing function of the debt contract's loan-to-value ratio and average period of debt. The basic reason why the interest rate increases with average period is this: the equity financing rate exceeds the interest rate, a lengthening debt average period reduces to equity the discounted cost of debt, the financing rate increases to re-establish equilibrium. The “embodied equity” hypothesis advanced herein joins the expectations hypothesis, the liquidity preference hypothesis, and the market segmentation hypothesis as a fundamental explanation for the upward slope on the yield curve.