Term Structure of Interest Rates: Yield Curve

Overview

In finance, the term structure of interest rates can be defined as the relationship among yields on financial instruments with identical tax, risk and liquidity characteristics. However, they give different terms to maturity. In other words, the finance term, “term structure of interest rates” refers to the relationship between bonds of different terms. In this case, the yield curve is constructed by plotting the interest rates of bonds against their terms.

The term structure of interest rates holds a lot of significance as economists and investors around the globe believe that the shape of the yield curve gives a clear idea of the market’s future expectation for interest rates and the conditions for monetary policy.

Definition Of Term Structure Of Interest Rates

The term structure of interest rates is a finance term which refers to the accord between the interest rates or bond yields and the different terms and maturities. IThis term is also known as the yield curve in finance and has a core impact on the economy. The curve that defines interest rates or yield at a certain point of time or maturity, the time can differ from the depending on the investment time limit. The line shows the accord between the interest rate and the time of maturity, which is dubbed as ‘Term’. 

The shape of the yield curve personifies the growing priorities of all lenders in relation to a certain borrower of a debtor. The wide usage of the yield curve is as a benchmark for other debts in the market, such as mortgage rates or bank lending rates.

Example of Term Structure Of Interest Rates

As we always say, concepts can be better understood with examples. Let us take you through two examples so that you can have a better idea of what Term structure of interest rates is:

The interest rates from U. S. dollar are invested on US Treasury securities for different maturities, and the investment processes are watched closely by many traders and investors, they assess the investment on the graph that is known as yield curve and the in a formal way, mathematical descriptions are called term structure of interest rates.

In most of the yield curve, Treasury securities that are plotted, are most-common type in yield curving, the reason is these securities are assessed as risk-free, it also considered as the benchmark of in order to decide the other yields of other debts.

What Is The Difference Between The Term Structure Of Interest Rates And The Yield Curve?

There is no major difference between the two terms, namely “term structure of interest rate” and “yield curve”. In fact, these two terms can be used interchangeably. However, the Yield Curve is the Yield To Maturity of the bonds in your curve, where YTM is an iterative calculator. In other words, “Yield To Maturity” states that all cash flows are discounted at the YTM.

On the other hand, the “term structure of interest rates” shows the various fields that are currently being offered on bonds of different maturities. It converts YTM’s to continuously compounded rates. This readily helps one compare yields offered on a short term, medium-term, and long-term bonds. For instance, investors can compare an annual rate paid two times a year versus an annual rate paid once a year using the “term structure of interest rates”.

Breaking Down Term Structure Of Interest Rates

As mentioned earlier, the term structure of interest rates is a relation between the interest rate and the maturity or horizon of the investment. In other words, it is the relationship among interest rates over different time horizons, as viewed from today, t = 0.

Here, the yield curve can be constructed by plotting the interest rates of bonds against their terms. The term structure of interest rates can be described using the Yield Curve and can take one of three yield curve shapes: normal, inverted or flat.

• A normal yield curve indicates that the yields increase as the maturity of the bonds increases in time. As the yields increase, they create a convex shape.

• Next comes the inverted yield curve, which indicates that short-term yields are higher than long-term yields. In this case, the curve droops downward in a concave manner, showing that yields and maturities are negatively inverted.

• Lastly, we have a flat yield curve. This yield curve shows that there is little or no variation between yields and maturities. It further indicates that all maturities have similar yields, thus making the yield curve parallel to the X-axis.

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