WITH REFERENCE TO THE UK EXPLAIN THE CONCEPT OF THE TERM STRUCTURE OF INTEREST? WHAT INFLUENCE DOES THE BANK OF ENGLAND HAVE OVER THE TERM STRUCTURE AND WHY IS IT IMPORTANT FOR MONETARY POLICY

To understand the term structure of interest rate we need to elaborate how interest rates function and how they are determined. Interest rates are a vital tool to all the macro-economic policy objectives of a government such as control of inflation, investment as well as employment. Interest rates refer to the price paid by deficit agents for borrowing funds from the surplus agents. A line that plots interest rate at a set point in time is the term structure or yield curve.

Interest rates which may be short term or long term are linked to a*…show more content…*

This particular curve is unusual as it is inverted. The market is anticipating a fall in rates and hence the shape of the yield curves. The sensitivity of such a curve can be explained taking into account that the change in the rates reflected is small, 0.24% over the duration of the security, 30 years. This is quite relevant when speculating on future economic conditions. (www.bankofengland.co.uk)

There are three main theories which relate to yield curves. The pure expectations theory implies that forward rates are unbiased estimators of future interest rates. This theory states that the term structure of interest rates reflects the views of the market about the path of future short term interest rates. Thus when explaining a positive yield curve, the market will be expecting short term interest rates to rise in the future. The opposite applies when the curve is negative and when flat the markets expect short term interest rates to remain approximately the same. This theory generally over -estimate interest rates and does not assume that investors are risk averse and want a higher return when investing.

The liquidity preference theory states that bond holders are risk averse and wish to be compensated for holding the long term security by a liquidity premium. The normal yield curve to explain this should be up sloping indicating preference for liquidity by investors and lower risk of shorter term

To understand the term structure of interest rate we need to elaborate how interest rates function and how they are determined. Interest rates are a vital tool to all the macro-economic policy objectives of a government such as control of inflation, investment as well as employment. Interest rates refer to the price paid by deficit agents for borrowing funds from the surplus agents. A line that plots interest rate at a set point in time is the term structure or yield curve.

Interest rates which may be short term or long term are linked to a

This particular curve is unusual as it is inverted. The market is anticipating a fall in rates and hence the shape of the yield curves. The sensitivity of such a curve can be explained taking into account that the change in the rates reflected is small, 0.24% over the duration of the security, 30 years. This is quite relevant when speculating on future economic conditions. (www.bankofengland.co.uk)

There are three main theories which relate to yield curves. The pure expectations theory implies that forward rates are unbiased estimators of future interest rates. This theory states that the term structure of interest rates reflects the views of the market about the path of future short term interest rates. Thus when explaining a positive yield curve, the market will be expecting short term interest rates to rise in the future. The opposite applies when the curve is negative and when flat the markets expect short term interest rates to remain approximately the same. This theory generally over -estimate interest rates and does not assume that investors are risk averse and want a higher return when investing.

The liquidity preference theory states that bond holders are risk averse and wish to be compensated for holding the long term security by a liquidity premium. The normal yield curve to explain this should be up sloping indicating preference for liquidity by investors and lower risk of shorter term

Related

- Decent Essays
## Term Structure of Interest Rates

- 1172 Words
- 5 Pages

Understanding the Term Structure of Interest Rates Prepared for Fundamentals of Financial Management Distributed October 24, 2005 TABLE OF CONTENTS List of Figures....................... ....................................... .....................iii List of Abbreviations and Symbols............................. ..........................iv Summary.............................................

- 1172 Words
- 5 Pages

Decent Essays - Better Essays
## Term Structure Of Interest Rates

- 1302 Words
- 6 Pages

Introduction 2 2. Method 2 3. Data 3 4. Results 4 5. Limitations 5 6. Suggested improvements 5 7. References 7 Introduction The term structure of interest rates describes the empirical relationship between the yields on fixed income securities and their term to maturity (Poitras, 2005). The yield curve is the term structure’s graphical representation, plotting the yields of fixed income securities as a “function of their maturity” (Stander 2005, Cochrane, 2005). Yield

- 1302 Words
- 6 Pages

Better Essays - Better Essays
## Interest Rate Is The Percentage Of A Loan That Must Be Paid On Top Of Whatever The Loan

- 2285 Words
- 10 Pages

An interest rate is the percentage of a loan that must be paid on top of whatever the loan was. For instance, if you borrowed four thousand dollars from the bank and they said that you have a 5% interest rate, this means that you will have to pay a total of four thousand, two hundred dollars. Interest rates on credits and securities give a fundamental synopsis of their attractiveness to banks. The premium rates in assigning supports crosswise over budgetary markets is very much alike to the costs

- 2285 Words
- 10 Pages

Better Essays - Good Essays
## Endogenous Money : Implications For The Money Supply Process, Interest Rates, And Macroeconomics Abstract

- 1389 Words
- 6 Pages

Endogenous Money: Implications for the Money Supply Process, Interest Rates, and Macroeconomics Abstract Endogenous money represents a mainstay of Post Keynesian (PK) macroeconomics. PK theory challenged monetarism’s description of the money supply process. The focus of PK endogenous money theory is the mechanics of the money supply process. PK theory is itself divided between “horizontalist” and “structuralist” approaches to the money supply. Horizontalists believe the behavior of financial institutions

- 1389 Words
- 6 Pages

Good Essays - Satisfactory Essays
## Advanced Managerial Finance

- 2203 Words
- 9 Pages

company calculate the long term debt-equity ratio for the prior two years. Why would these companies use such different capitals structures? 2. Look up a company and download the annual income statements. For the most recent year, calculate the average tax rate and EBIT, and find the total interest expense. From the annual balance sheets calculate the total long-term debts (including the portion due within one year). Using the interest expense and total long term debts, calculate the average

- 2203 Words
- 9 Pages

Satisfactory Essays - Satisfactory Essays
## Analysis of Fixed Income Investments

- 713 Words
- 3 Pages

Question 1 Are interest rate changes predictable? Interest rates are not entirely predictable but can be inferred from present interest rate prices. For example, when current interest rates are exceptionally low, future interest rates can be expected to rise and vice versa. Question 2 Consider a two year coupon bond which pays an annual coupon of 5% with a principal value of $100. Using the zero coupon bonds B(0, 1) and B(0, 2): 1. What is the strategy to replicate the coupon bond? 2. What

- 713 Words
- 3 Pages

Satisfactory Essays - Better Essays
## Ownership Structure And Ownership Structures

- 1710 Words
- 7 Pages

Ownership Structure Besides deciding whether to purchase a new or established property, buyers also need to decide on the ownership structure of their property. As we are all unique individuals, there are different ownership structures that can be beneficial for different people. The structure you choose will be dependent on your own individual circumstances. The most common ownership structures include the following: Individual Ownership, as the name implies, means that the property is owned by

- 1710 Words
- 7 Pages

Better Essays - Better Essays
## Assessment Of Interest Rate Risk

- 1979 Words
- 8 Pages

Assessment of Interest Rate Risk This study presents a comprehensive assessment of the interest rate risk. Risk is an expression of severity and possibility of loss that applies to every operation or human activity in all spheres of life (Kulpa, & Magdoń, 2012). The Basel II Accord, as a cornerstone of a formal quantitative framework of risk management, proposed to quantify interest rate risk by requiring that financial institutions retain a minimum level of capital to guarantee that obligations

- 1979 Words
- 8 Pages

Better Essays - Satisfactory Essays
## Finance Term Paper

- 738 Words
- 3 Pages

the yield to maturity equal to the interest rate, 4%? The bond has a face value of $1,000 and pays annual coupons. (b) What is the price of an annual coupon bond with a face value of $1,000, a coupon rate of 10%, and 30 years to maturity? 1 4. Suppose the term structure of interest rates are not ﬂat. The one year spot rate, r1 , is 6.01%/year, the two-year and the three-year spot rates, r2 and r3 , are both 5%/year. (a) What are the forward interest rates for the second and the third year

- 738 Words
- 3 Pages

Satisfactory Essays - Better Essays
## Financing, Debt, And Equity Debt

- 1738 Words
- 7 Pages

It is important to create a context when looking at funding structure as each industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar.A debt

- 1738 Words
- 7 Pages

Better Essays