Question

Explain the term structure of interest rates and the relationship measured. Why must all securitiesplottedonagiventermstructurehaveequaldefaultrisk?

Answer 1

Term structure of interest rate will be reflecting the plotting of bond yields of various long term and short term of similar nature and it will be used for predicting the state of economy as well as it is done in order to compare the rate of return of various bonds according to their duration.

Term structure is used for determination of various states of economy because when the term structure will be upward sloping it will mean that long term Bond yields are higher than the short term Bond yields and it is reflecting the expectation of growth in the economy in the long run.

Inverted term structure would be representation of a impending recession in the economy because investors will be expecting lower return on long term bonds and it will mean that on the longer period they are expecting lower growth so it will be representative of a downward cycle in the economy.

All securities which are plotted on a given term structure have equal default risk because all these securities are of similar quality which are plotted on a term structure because they can only be compared when they have equal default risk, else various security will be providing with different returns if they have different default risk so term structural only permits comparison between those bonds which are of similar nature and they have similar default risk.