Introduction to Finance

term structure of interest rates
indicates the relationship between interest rates 
or yields and the maturity of comparable quality debt instruments. This relationship 
is typically depicted through the graphic presentation of a 
yield curve
. A properly con-
structed yield curve must fi rst refl ect securities of similar default risk. Second, the yield 
curve must represent a particular point in time, and the interest rates should refl ect yields 
for the remaining time to maturity. That is, the yields should not only include stated interest 
rates but also consider that instruments and securities could be selling above or below their 
redemption values. (The process for calculating yields to maturity is shown in Chapter 9.) 
Third, the yield curve must show yields on a number of securities with diff ering lengths of 
time to maturity.
U.S. government securities provide the best basis for constructing yield curves because 
Treasury securities are considered to be risk free, as previously noted in terms of default 
risk. 
Table 8.3
contains interest rates for Treasury securities for various maturities at selected 
dates. In early 1980, the annual infl ation rate was in double digits. As a result, interest rates 
were very high, even though the economy was in a mild recession. By the latter part of the 
1980s, interest rates had dropped dramatically because of reduced infl ation. Interest rates on 
one-year Treasury bills were at 6 percent in March 1991, compared with 14 percent in March 
1980. Interest rates declined further as the economy began expanding from a mild recession 
at the beginning of the 1990s.
By November 1998, after the Fed fi rst pushed up short-term interest rates in an eff ort 
to head off possible renewed infl ation and then lowered rates in an eff ort to avoid a reces-
sion during the mid-1990s, interest rates were relatively fl at across diff erent maturities. The 
Fed lowered its discount rate many times during the fi rst years of the twenty-fi rst century