A Note on the "Traditional Theory" of the Term Structure of Interest Rates and Rates on Three- and Six- Month Treasury Bills

Abstract

ACCORDING TO traditional theory, investor is faced with a series of alternative investments which vary from one another in that some are of longer duration than others.' Thus, if investor can invest in either a loan which will mature in one week or in a loan which will mature in two weeks, traditional doctrine asks, which will he choose? He will probably be indifferent if administrative cost of buying one-week maturity and reinvesting proceeds in another one-week maturity is zero and if price of one-week loans does not change. If price of a one-week loan increases (the interest rate decreases) at end of first week, and he has to pay a higher price when he reinvests in another one-week maturity, he will be unhappy. If price of one-week loans decreases between time he purchases one and time at which he reinvests, he will be happy. If he is able to foresee future, he will know about change in price of one-week loans after first week, after second, third and on into infinity weeks, and he can adjust price he is willing to pay on loans of varying duration accordingly. In other words, investor only wants one rate of return (interest rate) on his loan (if he invests in a long-term bond) or his series of loans (if he invests in a series of short-term loans), but in order to obtain one net effective interest rate return he must insist that market interest rate on loans of varying duration be different. This must be neo-classical meaning of interest rate. If he knows that rate on one-week loans one week hence will be higher than current rate, he will insist that rate he receives on a twoweek loan be an average of one-week loan rate now and one week from now. Thus, the long rate is the... average between current short rate and relevant forward short rates.'2 Assuming simple interest, relationship between short (for