S treasury bills is a proxy for the risk free rate

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Term Structure of Interest RatesThe term structure of interest rates refers to the relationship between yield tomaturity and term-to-maturity on a bondThe graph of the term structure of interest rates is a yield curveThe shape and position of the yield curve are not constantAs the overall level of interest rates changes, the yield curve shifts up anddown and changes its shape and slopeBasic shapes of yield curves:Ascending or normal yield curves slope upward from left to right and implyhigher interest rates are likelyDescending or inverted yield curves slope downward from left to right andimply lower interest rates are likelyFlat yield curves imply interest rates are unlikely to changeFactors that shape the Yield CurveReal rate of interestThe real rate of interest changes with the business cycleThe highest rates occur at the end of an economic expansionThe lowest rates occur at the end of an economic contractionChanges in the expected future real rate of interest can affect the slope of theyield curveExpected rate of inflationIf higher inflation is forecast, the yield curve will slope upward becauselonger-term yields will contain a larger inflation premium than shorter-termyieldsIf investors believe inflation will subside, the yield curve will slope downwardInterest rate riskThe longer the maturity of a security, the greater its interest rate risk (the riskof selling the security at a lower price) and the higher the YTMThe interest rate risk premium adds upward bias to the slope of the yield curve
The Structure of Interest RatesCumulative effect of factors that shape the yield curve:In an economic expansion, The real rate of interest and inflation premium increase monotonically Interest rate risk increasesIn an economic contraction, The real rate of interest and inflation premium decrease monotonicallyInterest rate risk decreases

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