March 18, 2004
The Term Structure of Interest Rates
Every day, the Wall Street Journal publishes the yield curve.
The link between short-term interest rates and long-term interest rates is very important because it is the link between monetary policy and investment, including mortgages and corporate bonds.
One explanation for RL - RS is a risk premium. Long-term assets have greater interest rate risk than do short-term assets.
The expectations hypothesis is an alternative explanation. To understand this idea, we studied the forward rate, which featuers the same math, but a different view of the future short-term interest rate.
If the one-year rate is 4% and the two-year rate is 6%, investors with known income for one year from the present can lock in an 8% forward rate over the second year.
While this is not an arbitrage profit, it could be a very attractive investment strategy. If a large volume builds up, there will be upward pressure on the loan rate for the first year and downward pressure on the two-year return as people borrow money for the first year and loan it out in the two-year market. If both interest rates are 5%, the forward rate is 5%.
