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Money and Banking


4. Term Structure of Interest Rates


We learned in a previous topic that the interest rate paid on a particular bond relative to other bonds in the market depends on many factors, including differences in default risk, differences in liquidity, and differences in tax rules. In this section, we focus on another factor: differences in the time to maturity. Bonds that have maturity dates at longer periods in the future typically (but not always) pay higher returns. The reasons have to do with bond buyers expectations for the future path of interest rates, the degree of uncertainty that bond buyers have over the future path of interest rates, and the degree of risk aversion that bond buyers have. We illustrate the different interest rates paid on bonds with different terms with the yield curve, and discuss what the shape of the yield curve implies for bond buyers expectations.


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Yield Curve: Liquidity Theory

We introduce the concept of the yield curve and provide a first explanation for its shape. The liquidity theory posits that longer-term bonds should pay a premium due to the higher degree of interest-rate risk, which suggests that the yield curve should be upward sloping. [Play Pencast]


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Yield Curve: Expectations Theory

The expectations theory provides another explanation for the shape of the yield curve. The expectations theory states that the interest rate on a long-term bond should equal the expected average short-term interest rate over that period. Whether bond buyers expect the short-term interest rate to increase or decrease over the life of a long-term bond will determine the slope of the yield curve. [Play Pencast]


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Yield Curve Example

In this Pencast, we combine the liquidity theory and the expectations theory to explain the shape of an example yield curve. [Play Pencast]


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Yield Curve at Onset of Recession

In this Pencast, we look at how the yield curve might be shaped if the economy is at the onset of a recession. In such a scenario, bond buyers might expect interest rates to fall during the recession, then rise again as the economy recovers from a recession. Given such a path for the expected interest rate, we look at how the yield curve would be shaped. [Play Pencast]


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Yield Curve in U.S. History: 1981

In this Pencast, we look at how the yield curve for the United States was shaped in 1981. At this point in U.S. history, inflation was recently at an all-time high and was just beginning to come down. [Play Pencast]


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