Investment Management: The Term Structure of Interest Rate

Pages: 8 (1178 words) Published: October 13, 2014




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INTRODUCTION In contrast to the asset price world, there is no commonly accepted model for the movement of the underlying in the interest rate world. Consequently, there are a number of different approaches to the pricing of fixed-income products. The simplest approach is to price a product of the term structure of interest rates which also known as yield curve. This method is effective for simple contracts, for instance bonds. Hiriyappa (2008)., This paper develops a technique of fitting a yield curve called “the term structure of interest rate” to observations on the prices securities with varying maturities and coupon rates. Also I will discuss the theories associated with term structure of interest rates, measure and describe the investment value of duration. THE TERM STRUCTURE OF INTEREST RATE The term structure of interest rates is also known as yield curve is a very common bond valuation method, Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed-income securities. The yield curve is a measure of the market's expectations of future interest rates given the current market conditions. Bodie, Kane, Marcus (2011), There are 3 main patters of created the term structure of interest rate are; Normal curve this is the curve that forms during the market conditions wherein investors generally believe that there will be no significant changes in economy, such as inflation rates, and the economy will continue growth at a normal rate. The graph bellow shown the normal yield cure

The graph above shows that price of the bond decrease as yield increase Flat Yield curve the curve indicates, the market environment is sending mixed signals to investors, who are interpreting interest movement in various ways. The graph below shows the flat yield curve, the graph also explain the theory of Expectations Hypothesis.

Invested yield curve, this curve is form during the extraordinary market conditions wherein the expectation of investors are completely the inverse of those demonstrated by the normal curve. Rufus I (2004)

THEORIES OF THE TERM STRUCTURE The Expectations Hypothesis, This hypothesis state that the forward rate equals the market consensus expectation of the future short interest rate; that is f2=E (r2) and liquidity premium are zero. For example, Suppose, one-year rates over the next five years are 4%, 7%, 7%, 8% and...
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