Explanatory Elements of the Deformations of the Term Structure of Interest Rates

Abstract

The interest rate curve has often been defined as a graphical representation of the yield offered by bonds of a single issuer according to their maturity, from shortest to longest. The best-known yield curve, which serve as a benchmark for the entire bond market in a given country, is that of the government bonds. Indeed, the shape of the interest rate curve on sovereign bonds provides information on investor’s expectations on the risk of default of the issuing state as well as on the level of inflation and future interest rates. As a result, it is a good indicator of the economic and financial health of the issuing country. In a stable economic environment marked by low inflation and sustainable public debt, bond yields increase with the maturity of securities. This is explained by the fact that the longer the maturity, the greater the risk of events occurring that could adversely affect the value of the bond security. Indeed, the further in time one goes, the greater the uncertainty about the issuer’s repayment capacity or about the level of interest rates. Under these conditions, investors require a risk premium to lend on long maturities compares to short maturities. However, as government loans are generally considered to be loans for which repayment is certain, the associated risk premiums are low or almost zero. On the longest maturities (20 to 50 years), the default risk as well as the interest rate or inflation risks can be considered to be broadly identical. This is the reason why the yield curves on government bonds of most "so-called" developed countries have an increasing and concave shape. This article highlights the explanatory factors of the structure of forward interest rates by proposing a multifactorial model of asset valuation that is at the same time exhaustive, simple, intelligible and realistic. The underlying objective is to propose techniques hedging against the risk of interest rates more effective than traditional techniques, especially since we live in an extremely sensitive and changing environment because of the consequences of covid-19 on economies. The contribution is part of the research movement aimed at improving the multifactorial models of the yield curve and to overcome the shortcomings of the techniques traditionally used.