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Unformatted text preview: Lecture 16 Sections 6.A: The Term Structure of Interest Rates (Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1 Spot Rates and Yield to Maturity • In chapter 6 we assumed interest was constant over all future periods. • In reality, interest rates vary through time. • The term structure of interest rates is a phenomenon that investments with different terms (amount of time) to maturity have different market interest rates. • As such, the term structure of interest rates affects bonds since they typically have a certain maturity date. • Why might there be inequality in interest rates over time? Maybe because inflation is expected to be higher over the second year than over the first, for • Example: With a twoyear spot rate of 10%, an investor that invests $1 in a twoyear bond receives $1.21 at date 2. • This is the same return as if the investor received the spot rate of 8% over the first year and 12.04% return over the second year. (i.e. $1x1.08x1.1204=$1.21). • When an investor invests in a twoyear zerocoupon bond yielding 10%, his wealth at the end of the two years is the same as if he received an 8% return over the first year and a 12.04% return over the second year. • The hypothetical rate over the second year, 12.04%, is called the forward rate. • A spot rate is the interest rate for a loan in which the loan is made today and is to be repaid at a certain time in the future. – If the loan is to be repaid in n periods, the spot rate is denoted rn....
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This note was uploaded on 02/08/2012 for the course ACTSC 371 taught by Professor Wood during the Fall '08 term at Waterloo.
 Fall '08
 Wood

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