THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 165

CHAPTER 6

The Risk and Term Structure of Interest Rates

133

Interest Rate (%)
16
14
12
January 1990

10

September 1986

8
6

March 1998

4

January 2009

2

0

1

2

3

4

5

5

10

15

20

Terms to Maturity (Years)

FIGURE 6-7

Yield Curves for Government of Canada Bonds, 1986 2009

Source: Statistics Canada CANSIM II Series V122531, V122532, V122533, V122538, V122539, V122540,
V122543, and V122544, and the authors calculations.

The upward-sloping yield curve in January 2009 indicates that short-term interest
rates would climb in the future. The long-term interest rate is above the short-term
interest rate when short-term interest rates are expected to rise because their average
plus the liquidity premium will be above the current short-term rate. The moderately
upward-sloping yield curve in September 1986 indicates that short-term interest rates

were expected neither to rise nor to fall in the near future. In this case, their average
remains the same as the current short-term rate, and the positive liquidity premium
for longer-term bonds explains the moderate upward slope of the yield curve.

A PP LI CATI O N

Using the Term Structure to Forecast Interest Rates
Interest-rate forecasts are extremely important to managers of financial institutions
because future changes in interest rates have a significant impact on the profitability of their institutions. Furthermore, interest-rate forecasts are needed when managers of financial institutions have to set interest rates on loans that are promised
to customers in the future. Our discussion of the term structure of interest rates has
indicated that the slope of the yield curve provides general information about the
market s prediction of the future path of interest rates. For example, a steeply