Running Head: TERM STRUCTURE OF INTEREST RATE 1

Term Structure of Interest Rate

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Introduction

Term structure of interest rate also known as the yield curve is a curve that matches the

interest rate with various maturity periods of different forms of debt. Based on the future

expectations by the investors, the yield curve exhibits different shapes that include normal curve

which is upward sloping, inverted curve which downwardly slopes, flatten curve and steepening

curve showing a rising gap between short term and long term interest rate. When uncertainty

increases in the economy, the yield curve is adversely affected. This paper analyses the term

structure of interest and how it is affected during uncertainty.

Term Structure of Interest rate (Yield Curve)

The term structure of interest rate is a curve that shows the interest rates over different

contractual lengths such as 3, 6 months, 1, 2 to 30 years of a debt. The period less than one year

is considered as a short term whereas a period of more than one year is considered to be long

term. The curve presents the relationship that exists between the interest rate and the maturity

time that is known as the term of a debt (Malkiel, 2015). Many investors watch closely the

interest rates that is paid on the treasury bills and plot a yield curve or term structure of interest

rate in order to predict the future behavior of the yield.

The yield curve shape is an indicative of priorities that lenders might have relative to a

given borrower or a single lender priorities relative to all the borrowers. Keeping all other factors

constant, the lenders would prefer holding their money at their disposal rather than the third

party’s disposal. Therefore, a price (interest rate) is given in order to convince them to lend. As

the maturity date of the loan increases, the lenders of funds demand a higher interest rate. This

follows uncertainties in the future periods such as potential risk of default as the term of the loan
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increases which makes them demand higher price. However, if the lenders are seriously looking

for long-term contracts as compared to short term ones, the yield curve inverts. The interest rates

decrease as the term of the increase and increase as the loan term decrease because it is easy for

the borrowers to attract long term lending.

Shape of the Yield curve

The curve is asymptotically upward sloping with diminishing marginal increase. As the

maturity of the loan increases, the interest rate increases by a lesser proportion than the previous

and eventually flattens (Joslin and Konchitchki, 2018). The reasons for upward sloping yield

curve is firstly, there may be an anticipation from the market that the risk free rate may rise.

According to arbitrage pricing theory, an investor that is willing not to invest the money now

have to receive a higher anticipated return in future. Secondly, a risk premium is required since

the longer the term of the loan the higher the uncertainty and there are higher chances of

catastrophic events happening that negatively impacts investment.

Types of yield curves

While there is no single yield curve that represents the cost of funds for everyone in the

economy, currency that securities are denominated is the most important factors influencing the

shape. Also the country’s economic conditions play an important role in determining the yield

curve.

Normal yield curve

This represents a rise in interest rate as the maturity term of the loan increases. The

positive slope presents the expectations by investor about an economy growing in future and is

associated with a greater inflation rate. The expected higher inflations implies that the central
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bank will in future tighten the monetary policy through offering short term interest in order to

slow the growing economy hence cut down the inflationary pressures. Due to the uncertainty

about the future inflation rate, the investors demand a higher interest rate to compensate for high

risk.

Steep yield curve

In steep yield curve, the difference between short term and long term bonds increases as

the yield curve steepens. As the gap increases, it is an indication that the long term bond yields

rises faster than the short term bonds but also can be expressed as the falling of short term bonds

as long term bonds rises. The steepening yield indicates investor expectation that inflation will

rise and a stronger economic growth is expected.

Flat yield curve

Flat yield curve is obtained in a situation when all the maturities carries the same yields.

It presents a lot of uncertainty in the economy. It indicates an inflation rate falling in future and

the economic growth is expected to slow down in future.

An Inverted yield curve

This kind of a curve occurs when the investors expects the short term interest rate to be

higher than the long term interest rates. Investors may opt for long term investment with low

yields if they expect a recession in the economy in the near future. An inverted yield curve

reveals a worsening economic condition in the future.

Effects of increased uncertainty on yield curve

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Uncertainty in the security market is created by fluctuations of prices, interest rates and

various economic policies. When interest rate changes discount rate is influenced which also

affects the prices. To presents correctly the behavior of yield curve under uncertainty, there is

need to look at the both short term and long term interest rate. While the former is administered

by the central bank, the latter is determined by the forces of demand and supply.

The activity of borrowing directly influences the economic activities. If the central bank

discovers that the economy is slowing down, it can lower the bank rate in order to stimulate

borrowing that will stimulate the economy (Leippold and Matthys, 2015). However, inflation

need to be taken into the account. On the other hand, long term interest rate is a function of the

impacts of the inflation induced by the current short term interest rates in the future. When

investors considers that the central bank has set the rate too low, then there is an increased

expectation of increase in inflation in future. This causes them to demand a higher interest rate in

order to compensate for the loss of purchasing power of their money due to inflation.

Conclusion

Term structure of interest rate illustrates various combination of interest rates and their

maturity periods. The shape of the yield curve depends on the expectations on how the economy

will perform in future. Low short term interest rates predicts a higher long term interest rate and

higher inflation associated with higher stimulated economy. Although uncertainty influences the

shape of the yield curve, increased uncertainty inverts the shape of the yield curve.
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References

Choudhry, M., 2019. Analysing and interpreting the yield curve. John Wiley & Sons.

Joslin, S. and Konchitchki, Y., 2018. Interest rate volatility, the yield curve, and the

macroeconomy. Journal of Financial Economics, 128(2), pp.344-362.

Leippold, M. and Matthys, F., 2015. Economic policy uncertainty and the yield curve. Available

at SSRN 2669500.

Malkiel, B.G., 2015. Term structure of interest rates: expectations and behavior patterns.

Princeton University Press.