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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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 Fall '08
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