Term Structure of Interest Rates

Understanding the Term Structure of Interest Rates

Prepared for Fundamentals of Financial Management

Distributed

October 24, 2005

TABLE OF CONTENTS

List of Figures.......................………………….......................................….....................iii

List of Abbreviations and Symbols.............................…………………..........................iv

Summary.............................................................................…………………...................5

Introduction..........................................………………….................................................7

Understanding the Term Structure of Interest Rates……….............…………...............8

Term Structure Puzzle................................................................8

The Yield Curve……………………………………………….8 The Expectations Theory………………………………………9

Visual Aids..............................................................................10

Conclusions……………………….........………………..............................…….............11

LIST OF FIGURES

Figure 1: Expected Yield Curve When Inflation Is Expected to Increase……………..4 Figure 2: Expected Yield Curve When Inflation Is Expected to Decrease..…………5
LIST OF ABBREVIATIONS AND SYMBOLS

k* Real Risk-Free Interest Rate

MRP Maturity Risk Premium

IP Inflation Premium

Fed Federal Reserve Board

KRF Quoted risk free interest rate on a treasury bill

FOMC Federal Open Market Committee

SUMMARY

In the article titled "Understanding the Term Structure of Interest Rates," William Poole examines relationship between short and long term interest rates over the past year. His analysis of these interest rates focuses on the fact that as the Fed