Term Structure Of Interest Rate Essay

1800 words - 8 pages

Explain the term structure of interest rates. What are the effects of rise in risk and expectations on the formation of long term rates?

Interest rate within an economy is subject to many factors and as a result varies in relativity of those. The major factors are time period: short term Vs. long term investments, the degree of risk to which its exposed (AAA rated, mortgages, default, zero coupon…).
Term structure of Interest rate is a significant tool for investors of bonds but also for policy makers, in terms of having an overview of whether to invest in short or longer term securities. This essay will go on to explain the term structure of interest rate how it is used by investors, ...view middle of the document...

This curves represents normal market conditions where investors behaviours indicate their beliefs of no changes in the economy e.g. stability of inflation rates etc. this is where investors are drawn to invest in long term bonds assuming their yield will be higher due to future market looking stable. This links to the known factor which is: the higher the risk the higher the return meaning that holding long term therefore more risky investments generates higher returns as the maturity prolongs the liquidity premium increases (as well as the maturity/risk premium).

However an upward slope is not always the case we notice that the upward slope is not steep and is not reflective of the market in all cases which brings us to the flat yield curve showing numerous movements within the markets. Uncertainty about the future then becomes stronger which encourages risk aversion meaning short term interest rate will rise as a result. This last result can lead to an inverted yield curve even though this is a rare condition which would most likely occur when future interest rate is known to drop which lead to investors opting for short term assets giving higher yield than those in the long term as the price of the bond is known to drop in the future.

Such a measure implements a projection of future performances since future spot interest rates are unknown the yield curve serves as a benchmark or an approximation of expected returns on these types of securities thus appeases the uncertainties dreaded by most investors.

The degree of risk will also affect investor’s decisions. Since the information about future of Interest rate is incomplete and it is known that the further into the future we try to forecast the more wrong we are, long term bonds hence present a greater risk. The term premium theories assume that most investors are risk averse and as we know interest rate is known increase as the maturity increases a premium on the return is generated. This addition to interest rate is needed to persuade risk adverse investors and savers to lend more long term securities.

The expectation theory suggests that observing the term structure is indeed a tool for market participants to forecast the future and therefore a cause of the different expectations. This theory represents an important tool as it has a major influence over the relationship between yield and the term to maturity of bonds. It shows how future changes affect the current structure if the yield curve shows stability it means that borrowers and lenders are at equilibrium of current patterns of IR in other word they are both lending and borrowing as much as each other .

The theory looks into future rates:

If long term is for 2years it will be demonstrated as:

Where iL= long term interest rate

As short term loans are of 1 year lenders might want to renew at the expected rate of 1 year by comparing it with the earning on the investment at...

Other Papers Like Term Structure of Interest Rate

Bonds Evaluation Essay

2198 words - 9 pages investor equals the security’s market value ( price ) would the investor’s required rate of return equal the security’s market yield. The Yield Curve Interest rates that are offered on investments ( or charged by banks on loans ) depends on the horizon ( or term ) of the investment or loan. The relationship between the investment term and the interest rate is called the term structure of interest rates. This relationship can be plotted on a

Case Study 2

2477 words - 10 pages work in the condition that the interest rates changes are not static. Banks can change their interest rate scenarios depending on many factors such as pricing and structure of assets and liabilities. Furthermore, the existing various of assumptions that underline simulation model make this method difficult to determine how much the variables changes in the level of the target account. Bank that used this simulation model can only performed only a

Advanced Managerial Finance

2212 words - 9 pages balance sheets calculate the total long-term debts (including the portion due within one year). Using the interest expense and total long term debts, calculate the average cost of debt. Next, find the estimated beta for the company on the S&P Stock Report. Use this reported beta, a current T-bill rate, and the historical average market risk premium found in a previous chapter to calculate the levered cost of equity. Now calculate the unleveraged

Reserve Bank

1178 words - 5 pages Department has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board. The cash rate is the rate charged on overnight loans between financial intermediaries. It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built. The close relationship between the cash rate and other money market

Asset and Liability Management

1107 words - 5 pages slotted into 3-month time bucket, its 5-year maturity being irrelevant for this objective ► Number of time buckets used depends on institution’s specific business and product concentration, and level of sophistication and liquidity of domestic interest rate markets Time buckets Typical bucket structure in US often looks as follows: * Overnight ● Up to one week ● > 1 week and ≤ 1 month ● > 1 month and ≤ 3

Lesson Plan

1029 words - 5 pages of Pounds Sterling and the risk associated with them as a foreign equity investment. Comment (I think the 2nd paragraph hits more on the points of the question) Mohsen This case is a cross currency interest rate swap. The motivation for both companies would be the limited access to specific currency and preferred interest rate structure. Thus, according to their comparative advantages, they raise capital at lower cost and then enter

Arundel Partners

329 words - 2 pages borrowing, which can only be achieved by keeping high interest coverage ratio and credit rating in the investment grade range. This explains the Diageo’s strategy for maintaining the high interest coverage ratio. Further, Diageo faces a risk of downgrade if its interest coverage ratio falls far below than 5x. In that case, its credit rating will fall to BBB (Non-Investment Grade) from A+ (Investment Grade). With Non-Investment Grade, it would be difficult for Diageo to raise cheap debt and to finance acquisitions. In addition to inorganic growth, high interest coverage and Investment Grade rating helps Diageo to raise short term debt at less interest rate. Current...

Monetary Policies In The Developing Countries

417 words - 2 pages the structure of reserve assets. In addition, over the past two years, the NBK periodically provided short-term liquidity to banks through automatic repo operations to smooth seasonal fluctuations in demand for tenge liquidity. Moreover, to enhance the transmission mechanism of monetary policy, the NBK was planning to engage in more active open market operations (OMOs) for both the introduction of a new policy interest rate. However, following the

Article I Want

5460 words - 22 pages and issue characteristic risks (RP). The nominal rate of interest for a security can be defined as r1 r* IP RP. For a 3-month U.S. Treasury bill, the nominal rate of interest can be stated as r1 r* IP. The default risk premium, RP, is assumed to be zero since the security is backed by the U.S. government; this security is commonly considered the risk-free asset. 2. The term structure of interest rates is the relationship of the rate of return

Corporate Finance Management and Modeling

1225 words - 5 pages rate could be explained by civilian employment- population ratio. Obviously, the second regression model is better than the first one. 4.4 Term Structure Hypothesis The U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one below which is informally called "the yield curve." More formal mathematical descriptions of this

Week 2 Dqs

587 words - 3 pages amount. For example, the current value for a future amount is based on certain interest rate and time period that is also referred to as discounting. The rate of return is the amount of money earned based on the amount of money invested to track all different types of investments. The average rate for short term investments and compound rate for long term investments are two ways the rate of return can be calculated. Based on the risk of the

Related Essays

Definition Of 'interest Rate' Essay

1683 words - 7 pages affect interest rates. The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend; the rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions", which is basically the buying or selling of previously issued U.S. securities. When the government buys more

Impact Of Interest Rate Swaps Essay

1476 words - 6 pages . Other factors to base the rates are the crash of the mortgage and automobile industries along with the LIBOR (The London Inter-Bank Offered Rate). The LIBOR plays a major role in the payment amount since this is the “benchmark for floating short-term interest rates and is set daily” (Bond Basics: What Are Interest Rate Swaps And How Do They Work, 2008 ). This as well as the weakening dollar allowed the gap to widen between the floating and the

The Valuation Effects Of Long Term Changes In Capital Structure

5473 words - 22 pages The valuation effects of long-term changes in capital structure ABSTRACT The objective of this study is to analyze and examine the changes in capital structure that do not affect the value of the firm and we have to know the relationship between the capital structure and the firm’s value. We are try to learn the changes in capital structure that do not affected the firm’s value and want to know relationship between the

Transaction Risk Essay

661 words - 3 pages invests its policy premiums in a long-term municipal bond portfolio.|Interest Risk |This example is an interest rate risk because the rate of |Both, Interest Rate and| | | |returns on the long-term municipal bond portfolio can |Interest Income