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The present prices of the bonds would help in the determination of the market rate of interest, or the price that would be paid for the use of the money for a period of time. There exists a functional relationship between the rate of interest and the time of the bonds. The term structure of interest rates or the yield curve shows the relationship between the rate of interest and the yields of the bonds with the terms to maturities. The curve is a representation of the various opportunities that may exist for the arbitrage as well as the expectation of the markets about the interest rates that may prevail in future. Interest Rates While carrying out the analysis of the yield curve it is essential to know the components of the nominal interest rates. This equation shows that the real rate of interest represented by r is the main component of the rate of interest. On the other hand, sigma is the risk premium that is being added to the rate of interest which is open to fluctuations due to various events. On the other hand, ? is the representative of the rate of inflation while l is the component that would capture the liquidity. The various financial markets would offer bonds and other long term instruments that would be offering a variety of interest or the rates of return (Kettell, 2001, pp. 19-26). The premium is the representation of the consumer behaviour that would depict that the consumers would be unwilling to hold that particular asset class. The following diagram shows the break-up of the various components of the rates of interest. The loans that are provided for the long term cost higher because the premium for liquidity would increase with the increase in the tenure of the bonds. The people would always want to hold liquidity at the present period of time rather than a later period. The opportunity cost of keeping the money in the hand would be less in the present period as compared to the future period. Yield Curve The yield curve is drawn from the yield to maturity of the bonds. The yield to maturity (YTM) is considered to be the approximate value of the rate of interest for a particular term to maturity of a bond. The various points of the terms to maturity and the corresponding yields to maturity are plotted on a plane and the curve that is fitted along these points is known as the yield curve. The following diagram is an example of a yield curve. In the plane the vertical axis measures the yield of the bonds and the horizontal axis measures the term to maturity of the bond. Figure 1: Yield curve The yield curve thus summarises yield of the different bonds that are being traded on a particular date. The yields or the different tenors in such cases may be different. The yield of a bond is the unique rate at which the cash flows that is provided by a bond is discounted. Thus even though the accrual of the cash flows are taking place at the different points in time the rate at which it is taking place is the same (Rossi, 2007, pp. 225-241). This rate is known as the yield to maturity of the bonds. In most cases the interest rates are considered to be fixed for the entire tenor. This would give rise to a flat yield curve as shown in the diagram below. Throughout the tenure of the bond the rate of interest that has been offered in case of this yield curve is 3.5%. Figure 2: Flat Yield Curve The ...Show more


Money, Banking & Finance Contents Contents 2 Introduction 3 Interest Rates 3 Yield Curve 4 Risk and Its effects 6 Pure Expectation Hypothesis 7 Liquidity preference theory 8 Preferred Habitat Hypothesis 8 Conclusion 9 References 10 Introduction Rates of interest are considered to be the price that is paid for a period of time for the usage of a sum of money…
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