Term Structure of Interest rates, Spot

rate & Forward rate

•Shruti Dodani
•Purva Badhe
•Dr. Ajitkumar Gudekar
•Dr. Mrunal Rane
•Mangal Dandekar
•Rashmi Ravikumar
 Introduction

Term Structure of Interest Rates

Important Definitions
Outline Theories
• Pure expectation hypothesis
• Liquidity preference hypothesis

Interpreting Term Structure

Predicting Bond Price

Risks

Conclusions
 Introduction
• Interest Rate:the amount charged over and above the principal amount by the
lender from the borrower
• how high the cost of borrowing is, or high the rewards are for saving .
• The term structure of interest rates refers to different interest rates that exist over
different term-to-maturity loans.
• In the most basic sense, theories to explain the term structure are still based on
interest rates equating the supply and demand for loanable funds.
• Different rates may exist over different terms because of expectations of changing
inflation and differing preferences regarding longer-term vs. shorter-term saving.
• Two main theories exist to enrich this explanation and help explain different rates
over different maturity terms.
Introduction

• The term structure of interest rates, commonly known as the yield curve, depicts
the interest rates of similar quality bonds at different maturities
• What is a common thread going through the whole macroeconomic system,
linking all the separate players such as the government, businesses, and
consumers? It is the interest rate
 Interest Rates

In economics, the relationship between different terms or maturities (for instance,

1 month, 1 year, or 10 years), and the interest rates for risk-free debt is called
the Term Structure of Interest Rates.
Interest Rates

• term structure of interest rates is the relationship between interest rates or bond
yields and different terms or maturities
• the term structure of interest rates is known as a yield curve, and it plays a crucial
role in identifying the current state of an economy.
• The term structure of interest rates refers to the market interest rates ( spot
rates) on bonds with different lengths of time to maturity but with the same or
similar risk ( with the same credit rating).
• It measures the relationship among yields on bonds that differ only in their term to
maturity
• The yield curve is a graph that plots the yield of various
bonds against their term to maturity.
• Yield curve takes different shapes. More formal mathematical
descriptions of this relation are often called the term
structure of interest rates.
 If we have a positively sloping yield curve, it means that the
market expects spot interest rates to rise. Likewise,
an inverted yield curve is an indication that spot rates are
expected to fall.
If the market expects inflationary pressures in the future, the
yield curve will be positively shaped, while if inflation
expectations are inclined towards disinflation, then the yield
curve will be negative.
The term of the structure of interest rates

Three primary shapes.

• Upward sloping—long-term yields are higher than short-term yields. This is
considered to be the "normal" slope of the yield curve and signals that the
economy is in an expansionary mode.
• Downward sloping—short-term yields are higher than long-term yields. Dubbed as
an "inverted" yield curve and signifies that the economy is in, or about to enter, a
recessive period.
• Flat—very little variation between short and long-term yields. This signals that the
market is unsure about the future direction of the economy.
Term Structure of Interest Rates

•Why do bonds with the same default rate and tax status but
different maturity dates have different yields?
•Long-term bonds are like a composite of a series of short-
term bonds.
•Their yield depends on what people expect to happen in the
future.
•How do we think about future interest rates?
Term Structure of Interest Rates

•The relationship among bonds with the same risk characteristics but different
maturities is called the term structure of interest rates.
•Comparing 3-month and 10-year Treasury yields we can see:
1. Interest rates of different maturities tend to move together.
2. Yields on short-term bonds are more volatile than yields on long-term bonds.
3. Long-term yields tend to be higher than short-term yields.
Information in the Term Structure of Interest
Rates

• Information on the term structure, particularly the slope of the yield curve - helps
to forecast general economic conditions.
•The yield curve usually slopes upward.
•On rare occasions, short-term interest rates exceed long-term yields leading to an
inverted yield curve.
•This is a valuable forecasting tool because it predicts a general economic
slowdown.
Indicates policy is tight because policymakers are attempting to slow economic
growth and inflation
• GDP growth and the slope of the yield
curve, measured as the difference between
the 10-year and 30
month yields: term spread.
• Panel A shows GDP growth together with
the growth and term spread at the same
time.
• Panel B shows GDP growth in the current
year against the slope of the yield curve
one year earlier.
• The two lines clearly move together.
Information in the Term Structure of Interest
Rates

• When the term spread falls, GDP growth tends to fall one
year later.
• This shows that the yield curve is a valuable forecasting tool.
• However, the yield curve did not predict the depth or
duration of the recession of 2007-2009.
• One and two year rates did not anticipate the persistent
plunge of overnight rates.
• The widening risk spread signaled a severe
economic downturn providing a more useful predictor in
this case.
• The slope of the yield curve can help predict the direction
and speed of economic growth.
• At the beginning of 2010 the yield curve was usually steep -
pointing to a strong economic expansion.
• In the aftermath of the financial crisis of 2007-2009, lenders
were especially caution about extending credit to risky
borrowers, even with narrow risk spreads.
https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?I
D=212

https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/64TA7209B
CEAE614655B88C0BD898C19EEF.PDF
https://slideplayer.com/slide/5314445/
https://slideplayer.com/slide/4349858/
https://slideplayer.com/slide/5959166/
Calculation : Interest Rate

• In real life, the term structure of interest rate is rarely

horizontal over the time. As you can see, the benchmark
interest rates either rise or decline as the maturity of debt
increases. In other words, the flat yield curve (b) is a
theoretical behavior of the interest rate in the perfect
capital market and this rarely happens.
• Now, we need to come up with some explanations to account
for the difference between the theoretical flat term structure