Explain the term structure of interest rates. What are the effects of Essay

Explain the term structure of interest rates. What are the effects of rise in risk and expectations on the formation of long term rates - Essay Example Change of short term interest rates by the central bank has an effect on domestic real economic conditions through its influence on the long-term interest rate and consequently on those of other countries should there be involved in trade. Investors are now more prone to foreign exchange and interest rate risks due to all these changes in the global market place. The term structure of interest rates represents the pattern for interest rates appropriate for discounting cash flows of various maturities. This is done through the use of a yield curve by plotting the interest rates against their terms so as to display the relationship between spot rates of zero-coupon securities and their term to maturity. The resulting curve allows an interest rate pattern to be determined, which can then be used to discount cash flows appropriately. Unfortunately, most bonds carry coupons, so the term structure must be determined using the prices of these securities. In the case of a zero-coupon bond, the yield to maturity is sometimes called the spot rate, as this rate is said to be the rate that The shape of the yield curve above is said to be a â€Å"normal yield curve† as it is thought to reflect the higher â€Å"inflation risk premium† that investors demand for longer term bonds especially as longer term interest rates are usually higher than shorter term interest rates. A â€Å"parallel shift† in the yield curve may occur provided the interest rates change by the same amount for bonds for all terms and when this occurs, the shape of the yield curve stays same although interest rates may appear to be higher or lower across the curve. But when interest rates for bonds of some terms change different than for other bonds, the yield curve may change and such a change is called the â€Å"twist†. But since term structures are continuously changing, the changes may result to the yield curve having its usual normal shape, or may even result to the curve to