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Explain The Term Structure Of Interest Rates

Essay

Finance & Accounting

Pages 7 (1757 words)

Introduction Interest rate is the cost of borrowing money. The term structure of interest rates defines the relationship between short and long term rates and the yield curve depicts this relationship graphically. Knowledge of interest rates is important to both, lenders and borrowers…

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## Introduction

Interest date data for bonds with different maturities date is published frequently and investors can use it to determine the term structure of interest rates. Some of the most popular interest rate data sources are the Wall Street Journal, Federal Reserve Bulletin and websites like Bloomberg and CNN. The term structure can be verified at any point in time by using published data from renowned sources. Yield curves are drawn using this published data on interest rates. There are short term and long term interest rates. Since long term interest rates have an element of maturity risk premium (MRP), they are usually higher than short term rates. When researching on the term structure of interest rates, it is important to have knowledge of commonly used terms like the Yield to Maturity (YTM), which is defined as the expected rate of return on a bond held till maturity (Brigham and Ehrhardt, 2010). Another concept which is discussed with YTM is that of the zero coupon bonds (or discount bonds). A zero coupon bond is a financial asset which at the date of maturity T, pays its holder a lump sum amount, with no coupon payments before the date of maturity (hence the name zero-coupon). The YTM at time t of a discount bond with maturity T is the constant and continuously compounded rate of rate of return at which the price of the bond accrues from time t to time T and pays one currency unit to the holder at time T. ...

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