term structure of interest rates

(noun)

the relationship between the interest on a debt contract and the maturity of the contract

Related Terms

Examples of term structure of interest rates in the following topics:

  • The Term Structure

    • Term structure of interest rates describes how rates change over time.
    • Term structure of interest rates is often referred to as the yield curve.
    • There are three main economic theories attempting to explain different term structures of interest rates.
    • The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
    • Differentiate between the different theories explaining the different term structures of interest rates

  • Term Structure of Interest Rates

    • Term structure of interest rates is the interest rates differ by maturity if the securities have identical risk, same liquidity, similar information costs, and the same taxes.
    • Economists define the term structure of interest rates for U.S. securities because the U.S. government issues a variety of securities with maturities ranging from 15 days to 30 years.
    • Interest rate on a long-term bond equals the average of the short-term interest rates expected to occur over the life of the long-term bond.
    • Investors become pessimistic about the future and reflect their pessimism in the term structure of interest rates.
    • Term Structure of Interest Rates for U.S.

  • The Yield Curve

    • A yield curve shows the relation between interest rate levels (or cost of borrowing) and the time to maturity.
    • The curve shows the relation between the (level of) interest rate (cost of borrowing) and the time to maturity, known as the "term," of the debt for a given borrower in a given currency.
    • Here, economic stagnation will have depressed short-term interest rates.
    • There are three main economic theories attempting to explain different term structures of interest rates.
    • The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.

  • Default Risk and Bond Price

    • Consequently, economists study these interest rates from these securities that they call the term structure of interest rates.
    • Then economists can plot the term structure, called the yield curve.
    • Yield curve usually slopes upward and means the long-term U.S. government securities pay a higher interest rate than the short-term ones.
    • Thus, the market interest rate always moves in the opposite direction of bond prices because of the present value formula.
    • Consequently, corporations pay greater interest rates for their bonds while the U.S. government pays a lower interest rate.

  • Long-Term Debt

    • Long-term debt is a means of financing that allows firms access to capital without diluting equity; capital & interest is paid off over time.
    • In the most basic terms, debt financing takes the form of short-term or long-term loans that must be repaid over a specified period of time, usually with interest.
    • Some use floating rates to determine the exact interest rate paid to bond holders.
    • Riskier investments will require compensation for the lender in the form of higher interest rates.
    • The actual effect of the firm's capital structure on firm value is a contested topic in financial theory (see Miller Modigliani Theorem).

  • The Interest Rate Risk

    • We show an example of a bank's balance sheet below:
    • Interest-rate sensitive items are short-term securities, variable interest-rate loans, and short-term deposits.
    • Moreover, the cost of funds increases by $2.5 million (0.05 × $50 million = $2.5 million).
    • If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
    • Third, the high volatility of interest rates during the 1980s contributed to the creation of new financial instrument, such as the floating-rate debt.

  • Macroeconomic Factors Influencing the Interest Rate

    • Taylor explained the rule of determining interest rates using three variables: inflation rate, GDP growth, and the real interest rate.
    • An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.
    • According to Taylor's original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:
    • In this equation, it is the target short-term nominal interest rate (e.g., the federal fund rates in the United States), πt is the rate of inflation as measured by the GDP deflator, π*t is the desired rate of inflation, r*t is the assumed equilibrium real interest rate, yt is the logarithm of real GDP, and y*t is the logarithm of potential output, as determined by a linear trend.
    • Taylor explained the rule in simple terms using three variables: inflation rate, GDP growth, and the equilibrium real interest rate.

  • The Fisher Effect

    • Investors and savers are concerned about the real interest rate because the real interest rate reflects the true cost of borrowing.
    • It equals a geometric average of the expected inflation rate and real interest rate.
    • However, if the inflation rate or interest rate becomes high, then the approximation loses accuracy as the cross term becomes large.
    • Accordingly, the price of bonds decreases and the interest rates increases.
    • Financial analysts always write interest rates for financial instruments in nominal terms.

  • Using the Yield Curve to Estimate Interest Rates in the Future

    • In short, through investor expectations of what the 1-year interest rates will be next year, the current 2-year interest rate can be calculated as the compounding of this year's 1-year interest rate by next year's expected 1-year interest rate.
    • (ist and ilt are the expected short-term and actual long-term interest rates, respectively)
    • It focuses on modeling the evolution of the interest rate curve (instantaneous forward rate curve in particular).
    • For the sake of this discussion, it suffices to say that the input of existing yield curves is useful in projected future interest rates under a number of varying perspectives.
    • Understand the conceptual implications of bond yield rates is they pertain to broader market interest rates

  • The Cost of Debt

    • The cost of debt is a component of the weighted average cost of capital (WACC) and is composed of the rate of interest paid.
    • They are usually long-term securities, having a maturity date falling at least a year after their issue date .
    • The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid.
    • In practice, the interest rate paid by the company can be modelled as the risk-free rate plus a risk component, taking into account credit risk; which is the amount of risk incurred by taking on more leverage in capital structure .
    • Cost of debt equals the interest rate of the debt (composed of the risk-free rate and a credit risk premium) times one, minus the corporate tax rate.