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 continues to increase its target for federal funds, the effects on short term and long term interest rates does not seem to be congruent with what is expected under the expectations theory. He refers to this as the term structure puzzle. Poole considers the expectations theory to try and solve this puzzle, and points out the fact that economic theory indicates that the a change in the bond rate should be linked to revisions in the future direction of the funds rate and not a to a change in the funds rate itself.

The underlying theory is that long term interest rates are in fact driven not by short term interest rates, but by new information about the current state of the economy. To prove this point he gives an example of how new information greatly affected both the short and long term interest rates but the expected recurrence

of that information did little to change the rates in the long term.

The conclusion is that the market seems to be on the same page as the Fed, and actual events have turned out to be very close the markets guess as to what would happen with expected changes in the Fed's policy. Because of this, he rejects the theory that there is a puzzle at all. There just has not been a need to greatly adjust the long term interest rates, because they are already in line with the markets expectations. His explanation follows the expectations theory. Under his theory, until new and unexpected information becomes available, the long term interest rates should be expected to maintain the same trend.

INTRODUCTION

This report contains my analysis of the article written by William Poole entitled, "Understanding the Term Structure of Interest Rates." I will discuss knowledge of this material, which was obtained in class. My discussion will focus on the term structure of interest rates, where I will discuss term structure puzzle, the yield curve, the pure expectations theory, and federal policy.

Understanding the Term Structure of Interest Rates Puzzle

The Term Structure Puzzle

This "puzzle" that Poole refers to the differences in interest rate patterns. As we have learned, long term interest rates are a weighted average of