Theories of term structure of interest rates pdf

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The US dollar yield curve as of February 9, 2005. The curve has a typical upward sloping shape. 2 month, 2 year, 20 year, etc. With other factors held equal, lenders will prefer to have funds at their disposal, rather than at the disposal of a third party.

The interest rate is the “price” paid to convince them to lend. The yield of a debt instrument is the overall rate of return available on the investment. In general the percentage per year that can be earned is dependent on the length of time that the money is invested. For example, a bank may offer a “savings rate” higher than the normal checking account rate if the customer is prepared to leave money untouched for five years.

This function Y is called the yield curve, and it is often, but not always, an increasing function of t. Yield curves are used by fixed income analysts, who analyze bonds and related securities, to understand conditions in financial markets and to seek trading opportunities. The British pound yield curve on February 9, 2005. There are two common explanations for upward sloping yield curves. A risk premium is needed by the market, since at longer durations there is more uncertainty and a greater chance of catastrophic events that impact the investment. This explanation depends on the notion that the economy faces more uncertainties in the distant future than in the near term.

For instance, in November 2004, the yield curve for UK Government bonds was partially inverted. The yield for the 10-year bond stood at 4. The market’s anticipation of falling interest rates causes such incidents. The shape of the yield curve is influenced by supply and demand: for instance, if there is a large demand for long bonds, for instance from pension funds to match their fixed liabilities to pensioners, and not enough bonds in existence to meet this demand, then the yields on long bonds can be expected to be low, irrespective of market participants’ views about future events. The yield curve may also be flat or hump-shaped, due to anticipated interest rates being steady, or short-term volatility outweighing long-term volatility. Yield curves continually move all the time that the markets are open, reflecting the market’s reaction to news.

There is no single yield curve describing the cost of money for everybody. The most important factor in determining a yield curve is the currency in which the securities are denominated. The economic position of the countries and companies using each currency is a primary factor in determining the yield curve. Different institutions borrow money at different rates, depending on their creditworthiness. These are constructed from the yields of bonds issued by corporations. Since corporations have less creditworthiness than most governments and most large banks, these yields are typically higher.