Question

2. What is an interest rate? What is the term structure of interest rates? What are some of the theories about the term structure and what do they imply about the shape of the term structure. What other things affect the different interest rates observed in the real world?

Answer 1

Answer:

Interest rate- It is the rate that lender charges from borrower on the loan and for use of that loan or asset for a particular time period. Interest rate is return rate for lender while expense for a borrower.

Term structure of Interest rate- It is a theory that tells relationship between the interest rate and bond yields at different maturities. When it is graphed, term structure of interest rate is known as Yield Curve. Yield curve is very important because it tells the current state and direction of the economy.

Term structure of interest rate has these three characteristics (In general conditions)-

• The yield on short term bonds are more volatile than long term bonds.
• The yields on long term bonds are higher than yields of short term bonds.
• The change in yields of different term bonds tend to move in the same direction.

Yield curve of term structure of interest rates has three important shapes-

(1): Upward sloping- Long term bonds' yields are higher than short term bonds' yields, it is considered a Normal shape and it is a sign that economy is in expansionary mode.

(2): Downward sloping- Short term yields are higher than long term yields, it is called Inverted yield curve because it shows that the economy is about to enter into a recession.

(3): Flat- If there is very little difference between short term and long term yields, it shows that market is not sure about the future direction of the economy.

Other factors that affect interest rates in the economy- Are as following:

• If the demand for money increases and supply remains constant then interest rates increase.
• If supply of money increases and demand remains constant then interest rates decrease.
• When there is inflation in the economy, Central bank increases interest rates to check and control the demand and consumption and vice versa.
• When economy is in boom, Central bank increases interest rates and when there is slow down in the economy so as to boost the economy, central bank lowers the interest rates.