Term Structure

Until now, we have assumed that the interest rate (or discount rate) remains constant throughout the term of the investment. However, this is not always the case.

Term Structure is the relation between the investment term and the interest rate.

The yield curve is a graph of the relation between the investment term and the interest rate.

A yield, y, is the one discount rate that when applied to the promised cash flows of the security, recover the price of the security.

Loosely, it is the same as R.

The slope of a yield curve indicates the direction in which future interest rates are likely to go, i.e. it indicates if interest rates are likely to increase or decrease.

The downward-sloping yield curves for 1981 and 2000 indicate a likely decrease in interest rates (yields) in the near future, while the upward-sloping yield curve for 2012 indicates an increase in interest rates in the near future.

• Treasury Yield Curves graph the relation between interest rates on risk-free loans and loan maturity

• Other yield curves graph the relation between interest rates on risky loans and loan maturity

Spot Rate: The spot rate is the interest rate for a loan made today. It varies based on maturity of the loan and risk.