Term Structure of Interest Rates•The term structure of interest rates refers to the relationship between yield tomaturity and term-to-maturity on a bond•The graph of the term structure of interest rates is a yield curve•The shape and position of the yield curve are not constant•As the overall level of interest rates changes, the yield curve shifts up anddown and changes its shape and slope•Basic shapes of yield curves:•Ascending or normal yield curves slope upward from left to right and implyhigher interest rates are likely•Descending or inverted yield curves slope downward from left to right andimply lower interest rates are likely•Flat yield curves imply interest rates are unlikely to changeFactors that shape the Yield Curve•Real rate of interest•The real rate of interest changes with the business cycle•The highest rates occur at the end of an economic expansion•The lowest rates occur at the end of an economic contraction•Changes in the expected future real rate of interest can affect the slope of theyield curve•Expected rate of inflation•If higher inflation is forecast, the yield curve will slope upward becauselonger-term yields will contain a larger inflation premium than shorter-termyields•If investors believe inflation will subside, the yield curve will slope downward•Interest rate risk•The 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 YTM•The interest rate risk premium adds upward bias to the slope of the yield curve

The Structure of Interest Rates•Cumulative 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 increases•In an economic contraction, •The real rate of interest and inflation premium decrease monotonically•Interest rate risk decreases