Term Structure of Interest Rates

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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.............................................................................…………………...................5 Introduction..........................................………………….................................................7 Understanding the Term Structure of Interest…show more content…
As we have learned, long term interest rates are a weighted average of short term interest rates. The short term interest rates are found by adding the real risk free rate of interest to the inflation premium. KRF = K* + IP According to this calculation, when there is an increase in the in the in KRF the long term bonds should increase by a weighted average of the new KRF. The Term Structure Puzzle is an occurrence when there is some deviation in this pattern and the yield curve does not match this weighted average. The Yield Curve We know that the term structure of interest rates describes the relationship between short and long term interest rates. What is important to understand when reading this article is to remember that the yield curve does not always have to be upward sloping. The rates on long term securities are only above short term rates if the yield curve is upward sloping or "normal." This is not always the case; depending on the expectations of the market the yield curve can also be "abnormal" or inverted if short term rates are expected to be higher than that of long term interest rates. It is also possible to have a humped yield curve if interest rates on medium securities are expected to be higher than both short and long term securities. By reviewing this information we can get a better picture of what Poole is talking about in his example of the term structure puzzle. In his example he talks about the funds target rate
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