Term Structure Of Interest RateS

Term Structure Of Interest Rates

Term Structure Of Interest Rates

The term structure of interest rates utilises the yield curve to contrive the yields of bonds with distinct maturities but with the identical risk, liquidity and levy considerations. It is the connection between the interest rates and the maturity of bonds. Three theories have been evolved to interpret the period structure of interest rates: (Arnold 1974)

1) the expectations idea,

2) the market segmentation theory and

3) the liquidity premium theory.

There are three important facts that these theories attempt to cover, they are: (Fabozzi 1995 152)

1. Interest rates on bonds should move together.

2. When short period interest rates are low, yield bends are more expected to have an up gradient; when short term interest rates are high, the yield bends are more likely to gradient downward.

3. Yield bends almost habitually gradient upward.

The first idea recounted is the anticipation idea and is founded on the assumption that investors are indifferent about the maturity of a bond in that they do outlook long period bonds as riskier that short period bonds. The anticipations theory furthermore assumes that bonds are perfect substitutes and their anticipated return should be equal. The idea proposes that the come back from buying into in a long period bond is habitually identical to the anticipated return from rolling over short period bonds. This can be shown easily with a numeric example: If today's one year rate is 6% and the following year's expected come back rate is 7% then the two year rate should be (6+7)/2 = 6.5%. (Adams 2001 250)

During an economic expansion the anticipation theory influences the shape of the yield bend because it displays investors anticipations about the future rates. Expansion is affiliated with rising interest rates and thus the yield bend will be up sloping. (Fabozzi 1995 85)

Theory and clues from the period Structure of borrowing Default Swap Spreads

Ren-raw Chen, Xiaolin Cheng, and Liuren Wu (2004), have been undertook to investigation the correlated between period structure of the interest rates, borrowing disperses and liquidity premium by utilising data set on borrowing default swaps(CDS). Findings in these items are established that behaviors of CDS vary significantly between commerce part, credit ranking, and liquidity. (Ball and Torous 1983) The period structure of the standard interest rates based on libor and swap rates under two-factor affine and quadratic model specification. The quadratic model interprets the libor well while the affine form presents much better on the swap rate. (Amin and Morton 1994)

Default appearance power is correlated with the interest-rate factors. Both of them affect credit disperse and the influence will moves in the credit-risk factors. Therefore, the authors utilising the interest-rate components to approximated credit-risk dynamics for each commerce parts and credit ranking groups. Estimations display that distinct industry parts and credit ranking groups have distinct borrowing risk dynamic. As a outcome, the high-liquidity businesses have higher CDS spreads contrast with low-liquidity group. (Black 1976)

Besides that, the added credit-risk and liquidity-risk component ...