term structure
Term Structure shows how interest rates change depending on how long you are willing to lend or invest your money, from a few months to many years.
In plain English
Why does the bank offer you a better rate for a two year fixed deposit than a three month one? That question is the whole idea behind term structure.
Term structure is simply the relationship between interest rates and time. Line up all the interest rates for different lengths of borrowing or lending, from ninety day treasury bills to twenty year bonds, and you get a curve. That curve tells a story about what lenders expect from the future.
In Nigeria, you see this when you compare treasury bills. A ninety one day bill might offer a lower rate than a three hundred and sixty four day bill, because the longer you tie down your money, the more you want to be paid for the wait and for the uncertainty of what inflation or the exchange rate might do in that time.
Someone in London sending money home might notice something similar with UK gilts. Short dated gilts and long dated gilts rarely pay the same, and the gap between them is watched closely because it hints at what the Bank of England and investors expect interest rates to do over time.
Sometimes the curve flips. Short term rates rise above long term rates, and people start whispering about a slowdown ahead, because that pattern has often shown up before economic trouble in the past.
Once you understand term structure, every interest rate you see stops looking random. It starts looking like a sentence in a longer conversation about time, risk and what the market believes is coming.
A Nigerian investor compares two treasury bills. The ninety one day bill yields 18 percent per year, while the three hundred and sixty four day bill yields 21 percent. The extra 3 percent is the market's way of paying the investor for locking up ₦2,000,000 for a much longer stretch of time.
Questions people ask
Is term structure the same as the yield curve?
Yes, in everyday use they mean the same thing. The yield curve is just the consider you get when you plot the term structure of interest rates on a graph, from short dated to long dated.
Why do longer term investments usually pay more?
Mostly because of risk and uncertainty. The longer your money is tied up, the more can change with inflation, the economy or the currency, so lenders and investors usually ask to be paid more to accept that wait.
Can the term structure ever be upside down?
Yes, this is called an inverted curve, where short term rates are higher than long term rates. It is unusual and often gets attention because it has sometimes appeared before economic slowdowns.
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