Bonds and Bond Derivatives, Second Edition

9

TERM STRUCTURE OF INTEREST RATES

This chapter focuses on the reasons why interest rates differ by maturity, or term. A schedule of spot interest rates by maturity is called the term structure of interest rates. The term structure can be rising, flat, declining, or humped.

The term structure is not directly observable, since no tax-free, default-free zero-coupon bonds exist. Analysts generally try to estimate the term structure from the yields for coupon-bearing bonds. A yield curve shows the relationship between interest rates and maturity for coupon-bearing bonds.

The first part of the chapter focuses on historical patterns observed for the term structure. The second part of the chapter deals with traditional theories explaining the term structure of interest rates. Modern mathematical models of the term structure constitute the last part of the chapter.

Historical Patterns in Yield Curves

The most frequent shape for yield curves is upward sloping. Downward-sloping yield curves have occurred at the end of the expansion phase of business cycles. At these business cycle peaks, heavy demand for credit, inflationary pressures, and tight money tend to push all interest rates to high levels. This business cycle pattern for the term structure is illustrated in Figure 9.1.

This pattern implies the following three empirical regularities for term structures:

1. The most common yield curve shape is upward sloping.
2. Declining yield curves occur when interest rates are historically high.