Term Structure of Interest Rates

Term Structure of Interest Rates: The interest rate of securities differs according to the characteristics of securities. The risk that securities carry, the liquidity feature, tax privileges and finally maturities differ from each other. When it comes to the structure of interest rates, it is understood how the differences in these properties of securities reflect on the interest rates.

Term Structure of Interest Rates

The interest rate of securities differs according to the characteristics of securities. The risk that securities carry, the liquidity feature, tax privileges and finally maturities differ from each other. When it comes to the structure of interest rates, it is understood how the differences in these properties of securities reflect on the interest rates. For example, we call the difference between the interest rates of securities at various maturities. With the same level of risk as the maturity structure of the interest rates.

Risk Structure of Interest Rates

The risk structure of interest rates aims to explain the differences between the interest rates of securities with the same maturity. Therefore, the risk structure of interest rates, the risk of non-repayment of securities. With the same maturity explains how differences in liquidity and tax privileges are reflected in the interest rate. We will consider how the differences in these factors will be reflected in the interest rate below.

Risk of Non-Reimbursement

The risk of non-reimbursement of a security that represents debt (such as bonds and bills) is the possibility that the economic unit issuing this securities. Will not fulfill its responsibilities (interest payment and principal repayment) on time. The unit, which issues this possibility, issuing securities should offer a higher interest rate to those who purchase it, in order to compensate for the risk they assume.

term structure of interest rates

In order to determine the risk of non-reimbursement for a security, a non-reimbursable security is needed. As we mentioned before, government bonds can fulfill this function. Since the state has the necessary power to raise taxes and impose new taxes, and beyond that. It holds the monopoly of printing money in the country, so the possibility of the state not to repay its debts is considered zero.

Therefore, debt securities issued by the public sector are called risk-free securities. When interpreting the concept of “risk-free” here, keep in mind that what is meant is independence from the risk of non-repayment.

Public Sector

Because the bonds and bills issued by the public sector always carry the interest rate risk. If we compare the interest rate of securities that do not bear the risk of non-reimbursement and the interest rates. Securities with such probability, it becomes possible to determine the risk of non-reimbursement. Accordingly, for example, the difference between government bond interest rates with the same maturity of a bond issued. By a private company is a measure of the risk of non-reimbursement. The difference between the interest rate of a security, which is independent of non-reimbursement risk. The interest rate of a security with the same maturity, is the risk premium.

Accordingly, the risk premium shows how much additional interest has been earned to purchase a risky bond. As you can remember from our previous explanations, the risk has an effect that increases the interest rate. Securities that carry the risk of non-repayment always carry a positive risk premium. The higher the risk, the higher the risk premium.

We can use Figure 5.1 to see how the risk of non-repayment is reflected in the risk premium and interest rate. In the figure, the private sector bond market with the same maturity and the government bond market are discussed separately.

In order to see more clearly how the risk premium is reflected in the interest rate. Let’s make a simplifying assumption and initially assume that private sector bonds do not bear the risk of non-reimbursement. In this case, the interest rates of these bonds with the same risks and maturities will be the same. As a matter of fact, according to the figure, the balance interest rates formed in both markets according to the starting balance points are at the same level.

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