2.13 Term structure of interest rates

Question 1

What is the term structure of interest rates?

Answer 1

It is the relationship between nominal interest rates of bonds and time to maturity

Question 2

What assumptions do you make about term structure of interest rates?

Answer 2

• there is no default risk

- we are working with zero-coupon bonds

Question 3

What should interest rates (their value) be?

Answer 3

• It is based on the market expectations theory that helps them find the value of the interest rates
• so e.g. despite two different securities, the return should be the same

Question 4

What is the market expectations theory?

Answer 4

The theory states that interest rates are set so that investors receive the same return regardless of the security/ies they invest in (given equal time horizons)

Question 5

What is the liquidty premium theory?

Answer 5

Interest rates are set by expectations BUT ALSO receive called LIQUIDITY PREMIUM in taking extra risk in longer term investment - a compensation

Question 6

What are some other determinants of interest rates?

Answer 6

• inflation: increased inflation implies increased in interest rates
• default risk: demand for higher interest rates due to increase in risk