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February 17, 2005

The Term Structure of Interest Rates

Events in the Wall Street Journal compelled us to talk about the term structure of interest rates a little early this semester. We begin with the definition of a forward rate.

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The forward rate of 5% turns 103 in 2006 into 108.16 in 2007.

The expectations hypothesis recasts this algebra to state that the current long-term rate is determined by the current short-term rate and the expected future short-term rate. The empirical rates include some component of the spread between short-term and long-term rates that can be identified as a risk premium. One of the risk is, of course, the possibility of higher future short-term rates so disentangling these concepts is difficult.

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Posted by bparke at February 17, 2005 10:18 PM

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