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Chapter 12. The Term Structure of Interest Rates

Chapter 12. The Term Structure of Interest Rates. The Yield Curve Spot and forward rates Theories of the Term Structure. Term structure. bonds with the same characteristics, but different maturities focus on Treasury yields same default risk, tax treatment similar liquidity

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Chapter 12. The Term Structure of Interest Rates

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  1. Chapter 12. The Term Structureof Interest Rates • The Yield Curve • Spot and forward rates • Theories of the Term Structure

  2. Term structure • bonds with the same characteristics, but different maturities • focus on Treasury yields • same default risk, tax treatment • similar liquidity • many choices of maturity

  3. Treasury securities • Tbills: • 4, 13, 26, and 52 weeks • zero coupon • Tnotes: • 2, 5, and 10 years • Tbonds: • 30 years (not since 2001) • Tnotes and Tbonds are coupon

  4. Treasury yields over time

  5. relationship between yield & maturity is NOT constant • sometimes short-term yields are highest, • most of the time long-term yields are highest

  6. I. The Yield Curve • plot of maturity vs. yield • slope of curve indicates relationship between maturity and yield • the living yield curve

  7. yield maturity upward sloping • yields rise w/ maturity (common) • July 1992, currently

  8. yield maturity downward sloping (inverted) • yield falls w/ maturity (rare) • April 1980

  9. yield maturity flat • yields similar for all maturities • June 2000

  10. yield maturity humped • intermediate yields are highest • May 2000

  11. Theories of the term structure • explain relationship between yield and maturity • what does the yield curve tell us?

  12. The Pure Expectations Theory • Assume: bond buyers do not have any preference about maturity i.e. bonds of different maturities are perfect substitutes

  13. LT = long-term • ST = short-term

  14. if assumption is true, then investors care only about expected return • if expect better return from ST bonds, only hold ST bonds • if expect better return from LT bonds, only hold LT bonds

  15. but investors hold both ST and LT bonds • so, • must EXPECT similar return: LT yields = average of the expected ST yields

  16. under exp. theory, • slope of yield curve tells us direction of expected future ST rates

  17. why? • if expect ST rates to RISE, then average of ST rates will be > current ST rate • so LT rates > ST rates • so yield curve SLOPES UP

  18. yield maturity ST rates expected to rise

  19. if expect ST rates to FALL, then average of ST rates will be < current ST rate • so LT rates < ST rates • so yield curve slopes DOWN

  20. yield maturity ST rates expected to fall

  21. if expect ST rates to STAY THE SAME, then average of ST rates will be = current ST rate • so LT rates = ST rates • so yield curve is FLAT

  22. yield maturity ST rates expected to stay the same

  23. yield maturity ST rates expected to rise, then fall

  24. Is this theory true? • not quite. • FACT: yield curve usually slopes up • but expectations theory would predict this only when ST rates are expected to rise • 50% of the time

  25. what went wrong? • back to assumption: bonds of different maturities are perfect substitutes • but this is not likely • long term bonds have greater price volatility • short term bonds have reinvestment risk

  26. assumption is too strict • so implication is not quite correct

  27. Liquidity Theory • assume: bonds of different maturities are imperfect substitutes, and investors PREFER ST bonds

  28. so if true, investors hold ST bonds UNLESS LT bonds offer higher yield as incentive higher yield = liquidity premium

  29. IF LT bond yields have a liquidity premium, then usually LT yields > ST yields or yield curve slopes up.

  30. Problem • How do we interpret yield curve? • slope due to 2 things: (1) exp. about future ST rates (2) size of liquidity premium • do not know size of liq. prem.

  31. yield maturity yield curve small liquidity premium • if liquidity premium is small, • then ST rates are expected to rise

  32. yield maturity yield curve large liquidity premium • if liquidity premium is larger, • then ST rates are expected to stay the same

  33. Preferred Habitat Theory • assume: bonds of different maturities are imperfect substitutes, and investor preference for ST bonds OR LT bonds is not constant

  34. liquidity premium could be positive or negative • yield curve very difficult to interpret • do not know size or sign of liquidity premium

  35. Segmented Markets Theory • assume: bonds of different maturities are NOT substitutes at all

  36. if assumption is true, • separate markets for ST and LT bonds • slope of yield curves tells us nothing about future ST rates • unrealistic to assume NO substitution bet. ST and LT bonds

  37. unrealistic to assume NO substitution

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