Lecture 2- the Term Structure of Interest Rates

What is the Term Structure of Interest Rates?

the relationship between yield to maturity and term to maturity

What is yield to maturity?

the total return an investor receives by holding the bond until it matures

What does the yield curve plot?

plots yield to maturity against term to maturity

What is term to maturity?

The amount of time until the bond reaches maturity ie is paid back in full

what happens to the yield curve when short term interest rates are high? and low?

high = slope down, low= slope up

What are the main uses of government bond yield curves?

to indicate economic activity and conditions, to be used as a benchmark for pricing other fixed income securities, to boost returns in bond investment strategies

What are the three main theories of the TSIR?

Segmented markets theory, expectations theory, preferred habit and liquidity theory

What are the main assumptions of the segmented markets theory?

Bonds of different maturities are not substitutes,

investors have strong preferences for bonds of particular maturities, so markets of assets are segmented according to their maturity

investors are risk averse

investors avoid transaction costs

What are the downsides of the segmented markets theory?

It is powerless in forecasting future rates, and it cannot explain why yield curves are almost always positive sloping, or why YCs of similar maturities can be very different

Who developed the expectations theory?

Ian Fisher (1896), Hicks (1939)

What are the main assumptions of the expectations theory?

investors are risk neutral

short and longer term assets are perfect substitutes

no transaction costs

What does the expectations theory show?

that longer term rates are an average of expected short term rates

decisions depend on the final income, since investors treat short and long term bonds as perfect substitutes

What problems are there with the expectation theory?

treats long-term and short-term bonds as equally attractive once expected returns match, but real investors dislike long-term risk.

in realty, longer rates seem to underreact to changes in the short-term rate

What are the main assumptions of the Preferred Habit and Liquidity Premium Theories of TSIR?

investors are assumed to prefer one market of assets to another, but are willing to trade in other markets, given a compensation (the term premium)

What is the difference between the preferred habit theory and the liquidity premium theory?

PHT: the term premium compensates for preferences ; LPT: the term premium compensates for risks

What is the term premium (in general terms)?

The extra fixed yield required for the investor to be attracted into a market

What are the problems with the PHT and LPT?

the spread between long-run and short-run cannot always help predict future short term rates

What are the main facts of yield curves?

1) YCs move together over time

2) when short term interest rates are low, YCs slope upwards and vice versa

3) almost always YCs are positive sloping, but can also be negative sloping or flat

4) on the same day, YCs of similar maturities but of different enterprises/countries can be very different as they account for risk, demand-supply and other conditions