**The term structure of interest rates, also called the yield
curve, is a graph that plots the yields of similar-quality bonds against their
maturities, from shortest to longest**

Important Notes:

·
The graph that plots coupon rates
against a range of maturities -- that graph is called the **spot curve**.
·
The graph that plots yields against a
range of maturities – that graph is called the **Yield curve.**

So, what is the difference between coupon rates and
yield rates? - *Yield rate is the interest
earned by the buyer on the bond purchased, and is expressed as a percentage of
the total investment. Coupon rate is the amount of interest derived every year,
expressed as a percentage of the bond’s face value.* *Yield rate and coupon rate are
directly correlated. The higher the rate of coupon bonds, the higher the yield
rate.*

As you know that the interest rate will not remain
same as the markets are dynamic and constantly changing. The variation in
interest rates arises because interest rates that lenders expect to receive and
borrowers are prepared to pay are influenced by some factors which do not
remain constant over the time; such factors are as follows:

·
Supply and Demand: We all know how the
prices influence by the supply and demand factors, same happens in case on
interest rates also. If there is more demand of finance in the market, then it
will push the interest rates up and if there is little demand of finance, then
it will push interest rates down.

·
Expected Future Inflation: As we know that
the return we receive on our investments is not the real return because of
inflation. Suppose you earn 8%p.a. and inflation exists in market at 6% p.a.
So, in real terms you approximately earned 2% p.a. So, lenders will expect the
interest rates they obtain that will cover inflation atleast. So, in the periods
of high inflation, interest rates will be high.

·
Tax Rates: Now investors will require a
certain level of return after tax. So, if tax rates are high, then the interest
rates may also high.

·
The term structure of interest rates takes
three primary shapes.

1.If
short-term yields are lower than long-term yields, the curve slopes upwards and
the curve is called a positive (or "normal") yield curve. the yield
curve is positive, this indicates that investors desire a higher rate of return
for taking the increased risk of lending their money for a longer time period.
Many economists also believe that a steep positive curve means that investors
expect strong future economic growth with higher future inflation and thus
higher interest rates.

2.If
short-term yields are higher than long-term yields, the curve slopes downwards
and the curve is called a negative (or "inverted") yield curve. a
sharply inverted curve means that investors expect sluggish economic growth
with lower future inflation and thus lower interest rates.

3.A
flat term structure of interest rates exists when there is little or no
variation between short and long-term yield rates. A flat curve generally
indicates that investors are unsure about future economic growth and inflation.
Note that we also assume flat yield curve in case on Immunisation.

The three most popular explanations for the fact that
interest rates vary according to the term of investment (or the three central theories that attempt to
explain why yield curves are shaped the way they are)

1. Expectations
Theory

2. Liquidity
Preference

3. Market
Segmentation

1.**Expectations
Theory: **Theory
assumes that the term structure of an interest contract only depends on the
shorter term segments for determining the pricing and interest rate of longer
maturities. It assumes that yields at higher maturities (such as that of 5,10,
or 30 year bonds), correspond exactly to future realized rates, and are
compounded from the yields on shorter maturities. The theory explains the yield
curve in terms of expected short-term rates. It is based on the idea
that the two-year yield is equal to a one-year bond today plus the expected
return on a one-year bond purchased one year from today. consider the following two
investment strategies:

1: Buy
$1 of one-year bond (the short bond) and when it matures buy another one-year bond.

2: Buy $1 of two-year bond (the long bond) and
hold it.

*According to the expectations theory,
they are perfect substitutes and their expected returns must be equal.*

*Scenario1***:
**An
expectation of fall in the interest rates (in near future), will make long term
investments more attractive and short-term investments less attractive. So,
investors will be more towards long-term bonds and thus demand for long term
bonds rises and then price for long-term bonds rises and yields will fall in
the long-term investments (due to negative correlation between price of bond
and its yield). For reference, see inverted curve graph

*Scenario2:* An expectation of rise in the interest
rates (in near future), will make short term investments more attractive and short-term
investments less attractive. So, investors will be more towards short-term
bonds and thus demand for short term bonds rises and then price for short-term
bonds rises and yields will fall in the short-term investments (due to negative
correlation between price of bond and its yield). For reference, see Normal
yield curve.

2.**Liquidity
Preference:** Even the default-free bonds are risky
because of uncertainty about inflation and future interest rates. The reason
for the increase in inflation risk over time is clear-cut. The bondholders care
about the purchasing power of the return – the real return – they receive from
bonds, not just the nominal dollar value of the coupon payments. Uncertainty
about inflation creates uncertainty about a bond’s real return, making the bond
a risky investment. The further we look into the future, the greater the
uncertainly about the level of inflation, which implies that a bond’s inflation
risk increases with its time to maturity. Interest-rate risk arises from a
mismatch between investor’s investment horizon and a bond’s time to maturity.
If a bondholder plans to sell a bond prior to maturity, changes in the interest
rate generate capital gains or losses. The longer the term of the bond, the
greater the price changes for a given change in interest rates and the larger
the potential for capital losses. As in case of inflation, the risk increases
with the term to maturity, so the compensation must increase as with it. The
buyer of long-term bonds would require compensation for the risks they are
taking buying long-term bonds. Therefore, yields on long term bonds will be
higher than short term bonds. *The liquidity preference theory views
bonds of different maturities as substitutes, but not perfect substitutes.*
Investors prefer short rather than long bonds because they are free of
inflation and interest rate risks. Therefore, they must be paid positive liquidity
(term) premium, to hold long-term bonds. The risk premium increases with time
to maturity, the liquidity premium theory tells us that the yield curve will
normally slope upwards, only rarely will it have lied flat or slope downwards

3.** ****Market
Segmentation:** Under this theory, the future shape of
the curve is going to be based on where the investors are most comfortable and
not where the market expects yields to go in the future. This theory assumes
that markets for different-maturity bonds are completely segmented. The
interest rate for each bond with a different maturity is then determined by the
supply of and demand for the bond with no effects from the expected returns on
other bonds with other maturities. In other words, longer bonds that have
associated with them inflation and interest rate risks are completely different
assets than the shorter bonds. Thus, *the bonds of different maturities are not
substitutes at all*, so the expected returns from a bond of one maturity
has no effect on the demand for a bond of another maturity. Because bonds of
shorter holding periods have lower inflation and interest rate risks, segmented
market theory predicts that yield on longer bonds will generally be higher,
which explains why the yield curve is usually upward sloping.

Bonds of different terms are attracted
to different investors, who will choose assets that are similar in terms of
their liabilities. If you have liability to pay after 20 years than you invest
in long term bonds (as in case of Pension Funds, where they have start paying
pension when person gets age 65 years or whatever the case may be). If you have
the liability to pay in near future maybe 6 months than its better to invest in
short term bonds (as in case of banks, where investors may withdraw a large
proportion of funds at very short notice.

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