Explain The Term Structure Of Interest Rates Essay

Explain The Term Structure Of Interest Rates - Essay ExampleInterest date data for bonds with different maturities date is published oft and investors can use it to de nameine the depot structure of care grade. Some of the most popular interest rate data sources are the Wall way Journal, Federal Reserve Bulletin and websites like Bloomberg and CNN. The term structure can be verified at any point in time by using published data from renowned sources. comport curves are drawn using this published data on interest rates. There are get around term and long term interest rates. Since long term interest rates have an element of maturity risk premium (MRP), they are normally higher than all of a sudden term rates. When researching on the term structure of interest rates, it is important to have knowledge of commonly used terms like the Yield to Maturity (YTM), which is defined as the expected rate of return on a bond held till maturity (Brigham and Ehrhardt, 2010). A nonher concept w hich is discussed with YTM is that of the zero coupon bonds (or discount bonds). A zero coupon bond is a financial asset which at the date of maturity T, pays its holder a lump center field amount, with no coupon payments before the date of maturity (hence the name zero-coupon). The YTM at time t of a discount bond with maturity T is the aeonian and continuously riseed rate of rate of return at which the price of the bond accrues from time t to time T and pays one currency social unit to the holder at time T. The YTM is also referred to as the spot rate and the notation R (t, T) is used for it. Spot rates are piddling term interest rates and the term structure of interest rates depicts the relationship between spot rates and their dates of maturity (Gibson, Lhabitant and Talay, 2010). Interest rates are not only used in discounting and pricing for zero-coupon bonds but also other financial derivatives because their prices are sensitive to interest rates. If we go beyond the sc ope of an item-by-item investor, we can see that interest rates are also important to corporations. This is because when corporations are doing project appraisals, they use interest rate for computing the net array value and the discounted payback period for a project. The cost of capital which is of prime importance to corporations also depends upon interest rates (Benninga and Wiener, 1998). It will be useful to allot the type of interest rate before discussing investment decisions and discounting. There are two main types of interest rates simple interest rate and compound interest rate. Simple rate of interest is interest on a lump sum principal amount and it does not itself earn interest. Quite turnaround to this, is the compound rate of interest which itself earns interest. Investment decisions and discounting are all predominantly based on compound interest rates (Kelly and Tracy, 2010) Long term interest rates are an average of short term interest rates. The relationship between short and long term interest rates involves expectations. For example, if it is expected that short term interest rates will fall then the long term interest rates will fall below the current short term rate. The contrary situation is also valid if it is expected that short term interest rates will increase then the long term interest rates will rise above the current short term rate. These two situations are possible only because long term rates are derived from short term rates. It is a general perception that long rates are greater than short rates and this is termed as the