Financial Markets and Institutions (2-downloads)

20-Year Bond

Averages

Three-Month Bills

(Short-Term)

Three-to-

Five-Year

Averages

Interest

Rate (%)

2010

2005

F I G U R E   5 . 4

Movements over Time of Interest Rates on U.S. Government

Bonds with Different Maturities

Source: Federal Reserve: 

www.federalreserve.gov/releases/h15/data.htm

.

---

Chapter 5 How Do Risk and Term Structure Affect Interest Rates?

99

its expected return is less than that of another bond with a different maturity. Bonds

that have this characteristic are said to be perfect substitutes. What this means in

practice is that if bonds with different maturities are perfect substitutes, the expected

return on these bonds must be equal.

To see how the assumption that bonds with different maturities are perfect sub-

stitutes leads to the expectations theory, let us consider the following two invest-

ment strategies: