The Term Structure of Interest Rates

Abstract

In order to simplify the analysis, whether of the determination of the rate of interest, as in Chapter 10, or of the demand for assets within the context of a portfolio adjustment model, it is necessary to reduce the size of the model to manageable proportions. This is often achieved by aggregation over assets which are close substitutes, where relative variations in supply will have little impact on prices. It is exactly such issues, whether long-dated bonds are close substitutes for short bonds or whether variations in the relative supply of bonds will affect the pattern of bond prices, that lie at the heart of arguments about the determination of the term structure of interest rates. It is, perhaps, unfortunate that analysis of the term structure often begins in a certainty context since then all assets are virtually perfect substitutes by definition, though the mechanics of the relationship between present bond rates, implicit forward rates, and present and forward bond prices can be set out more easily in such circumstances.