What is the term structure of interest rates? How are spot interest rates determined from coupon bond prices?
What will be an ideal response?
The term structure of interest rates is the relation between the maturities of bonds and the pure discount bond yields, which are the spot interest rates for the various maturities. At the shortest maturities, one typically has spot interest rates from pure discount bond prices. One can then begin to use coupon bonds at longer maturities, discounting the early coupons at the known spot interest rates for those maturities and determining the final spot interest rate by finding the discount rate such that discounting the final coupon and principal payment provides a present value equal to the bond price minus the present value of the intervening coupon payments.
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