Read full version paper structure of interest rates
structure of interest ratesJoin AllFreePapers.com
Autor: refreshment 25 March 2011
Words: 439 | Pages: 2
The intention of this paper is to study the term structure of interest rates. Short -term and long-term interest rates differ at any point of time. The relationship between them shows the pure time value of money for different lengths of time and is called the term structure of interest rates. It can be upward sloping, downward sloping or "humped' depending on what kind of rates are higher. The emphasis of this study lies in the fact that the shape of the term structure is determined by three basic components: the real rate of interest, the rate of inflation and the interest rate risk. The real rate of interest mostly influences the overall level of interest rates. The prospect of future inflation strongly influences the shape of the term structure. An upward-sloping term structure may be a reflection of anticipated increases in inflation and a downward-sloping term structure - of the anticipated decrease. Investors in view of future inflation may demand compensation for this loss, i.e. inflation premium. The third component has to do with interest rate risk. Longer-term bonds have much greater risk of loss than do shorter-term bonds. Investors can demand extra compensation for this risk, which is called the interest rate risk premium. It is concluded that the term structure reflects the combined effect of the real rate of interest, the inflation premium, and the interest rate risk premium. easury yield curve and the term structure of interest rates are the same thing with the only difference that the term structure is based on pure discount bonds, and the yield curve is based on coupon bond yields. Treasury yields depend on three components: the real rate, expected future inflation and the interest rate risk premium. Treasury notes and bonds are default-free, taxable and highly liquid.
The results of the study show that there are considered some additional factors when bonds issued by corporations or municipalities are. The first factor is credit risk, the possibility of default. Lower-rated bonds will have higher yields. A bond's yield is calculated assuming that all the promised payment will be made, so it is actually a promised yield. Bonds free from taxes have much lower yields than taxable bonds. Investors demand the extra yield on taxable bond as compensation for the unfavourable tax treatment. Bonds have varying degrees of liquidity. Less liquid bonds will have higher yields than more liquid bonds.
In conclusion it can be said that bond yields depend on 6 things:1)real rate 2) expected future inflation 3) interest rate risk 4)default risk 5) taxability 6) lack of liquidity