Term structure of interest rates:

The theories of the determination of interest rates discussed above are mainly theoretical constructs that seek to provide an explanation of the level of the average, or natural rate of interest. These do not go very far in explaining the vast array and variety of interest rates prevailing in several different types of financial markets. We can ask: what explains the difference in the levels of long run and short-run interest rates? What explains the basic structure of interest rates? There are situations where different assets have different risks of default. For example the interest owed by a farmer to a moneylender may have a greater risk of not being paid (the loan to the farmer has a greater risk of default) than interest on a government bond. Differences in the level of risk of default can lead to differences in the rate of interest charged. The phrase 'term structure of interest rates' refers to the yields of interest-bearing instruments such as bonds which are equal except for maturity dates, that is, their terms to maturity differs.

We look at debts that are issued by lenders that are more or less identical; the only difference in the debt instrument is in the times at which these mature. Differences in yield caused by differences in the maturity period are called the term structure of interest rates. We can depict graphically the relationship between interest rates of the debt instrument and their maturity period. This graphical relationship is called the yield curve. It summarises the yields that one can earn by purchasing otherwise identical debt instrument of varying maturities. Yield curves can be mapped for instruments such as Treasury Bills bonds, Certificates of  Deposits etc. A yield curve is a picture at a certain moment of time. At a different time, the rate of interest may change and so may the yield curve. In a yield curve what we allow the maturity period to vary but hold constant the date at which the curve is  relevant, as well as the default risk associated with the particular instrument. Yield curves are usually upward sloping. However in rare cases when the yields of different instruments do not vary much among each other, the yield curve may even be almost horizontal.

Similarly in rarer situations when the yield on longer-term instruments is lower than the yield on shorter-term instruments, the yield curve may even be downward sloping. Historically, a few episodes of flat and even downward-sloping yield curves have occurred.