TERM STRUCTURE OF INTEREST RATES

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Lesson 06

TERM STRUCTURE OF INTEREST RATES

The relationship between long tem & short-term rates is known as Term Structure.

Interest rates in short & long terms are different. Term structure tells us nominal interest rate on default

free securities. When long-term rate is greater than short term then the term structure will be upward

sloping and when short-term rate is greater than the long term, the term structure will be downward

sloping.

The term structure of interest rates, also known as the yield curve, is a very common bond valuation

method.

There are three main patterns created by the term structure of interest rates:

1) Normal Yield Curve:

As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein

investors generally believe that there will be no significant changes in the economy, such as in inflation

rates, and that the economy will continue to grow at a normal rate. During such conditions, investors expect

higher yields for fixed income instruments with long-term maturities that occur farther into the future. In

other words, the market expects long-term fixed income securities to offer higher yields than short-term

fixed income securities. This is a normal expectation of the market because short-term instruments generally

hold less risk than long-term instruments; the farther into the future the bond's maturity, the more time and,

therefore, uncertainty the bondholder faces before being paid back the principal. To invest in one

instrument for a longer period of time, an investor needs to be compensated for undertaking the additional

risk.

Remember that as general current interest rates increase, the price of a bond will decrease and its yield will

increase.

2) Flat Yield Curve:

These curves indicate that the market environment is sending mixed signals to investors, who are interpreting

interest rate movements in various ways. During such an environment, it is difficult for the market to determine

whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually

occurs when the market is making a transition that emits different but simultaneous indications of what interest

rates will do. In other words, there may be some signals that short-term interest rates will raise and other signals

that long-term interest rates will fall. This condition will create a curve that is flatter than its normal positive

slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-income

securities with the least risk, or highest credit quality. In the rare instances wherein long-term interest rates

decline, a flat curve can sometimes lead to an inverted curve.

3) Inverted Yield Curve:

These yield curves are rare, and they form during extraordinary market conditions wherein the expectations

of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal

market environments, bonds with maturity dates further into the future are expected to offer lower yields

than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects

interest rates to decline as time moves farther into the future, which in turn means the market expects yields

of long-term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and

yields decline.

You may be wondering why investors would choose to purchase long-term fixed-income investments when

there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking

on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will

soon experience a slowdown, which causes future interest rates to give even lower yields. Before a

slowdown, it is better to lock money into long-term investments at present prevailing yields, because future

yields will be even lower.

REAL VS NOMINAL INTEREST RATES:

The nominal interest rate is the amount, in money terms, of interest payable.

For example, suppose household deposits $100 with a bank for 1 year and they receive interest of $10.

At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.

Corporate Finance FIN 622

The real interest rate, which measures the purchasing power of interest receipts, is calculated by

adjusting the nominal rate charged to take inflation into account.

If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the

year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.

After the fact, the 'realized' real interest rate, which has actually occurred, is:

ir = in -- p

where p = the actual inflation rate over the year.

The expected real returns on an investment, before it is made, are:

ir = in -- pe

where:

in = nominal interest rate

ir = real interest rate

pe = expected or projected inflation over the year.

Market interest rates

There is a market for investments which ultimately includes the money market, bond market, stock

market and currency market as well as retail financial institutions like banks.

Exactly how these markets function is a complex question. However, economists generally agree that

the interest rates yielded by any investment take into account:

The risk-free cost of capital

Inflationary expectations

The level of risk in the investment

The costs of the transaction

Risk-free cost of capital

The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever entirely risk-

free, bills issued by major nations are generally regarded as risk-free benchmarks.

This rate incorporates the deferred consumption and alternative investments elements of interest.

Inflationary expectations

According to the theory of rational expectations, people form an expectation of what will happen to

inflation in the future. They then ensure that they offer or ask a nominal interest rate that means they

have the appropriate real interest rate on their investment.

This is given by the formula:

in = ir + pe

Where:

in = offered nominal interest rate

ir = desired real interest rate

pe = inflationary expectations

Risk

The level of risk in investments is taken into consideration. This is why very volatile investments like

shares and junk bonds have higher returns than safer ones like government bonds.

The extra interest charged on a risky investment is the risk premium. The required risk premium is

dependent on the risk preferences of the lender.

If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns to double.

So for an investment normally returning $100 they would require $200 back. A risk-averse lender would

require more than $200 back and a risk-loving lender less than $200. Evidence suggests that most

lenders are in fact risk-averse.

Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans

are exposed to more risk of default during their duration.

Liquidity preference

Most investors prefer their money to be in cash than in less fungible investments. Cash is on hand to be

spent immediately if the need arises, but some investments require time or effort to transfer into spend able

Corporate Finance FIN 622

form. This is known as liquidity preference. A 10-year loan, for instance, is very illiquid compared to a 1-

year loan. A 10-year US Treasury bond, however, is liquid because it can easily be sold on the market.

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