FIN 420 Chapter 10 Section 6

Yield Curve

A graph showing the relationship between a bond’s YTM and it’s time to maturity.

Term Structure of Interest Rates

The relationship between interest rates (YTM) and the time to maturity of bonds.

What are the four types of yield curves?

• Upward-sloping (normal): Long-term yields are higher than short-term yields.

• Downward-sloping (inverted): Short-term yields are higher than long-term yields.

• Flat: Short-term and long-term yields are approximately equal.

• Hump-shaped: Yields initially rise and then fall.

What does an inverted yield curve indicate?

It suggests that future short-term interest rates may decrease and is often considered a warning sign of a possible recession.

Expectations Theory

The shape of the yield curve reflects investors’ expectations about future short term interest rates.

How do expected future interest rates affect the yield curve under Expectations Theory?

• Rates expected to rise → Upward-sloping curve.

• Rates expected to fall → Downward-sloping curve.

• Rates expected to stay constant → Flat curve.

Spot Rate

YTM on zero coupon bond for specific maturity.

Foward Rate

Implied interest rate for future period, calculated from current bond yields.

What does Expectations Theory predict about expected holding-period returns?

Bonds of different maturities should offer equal expected holding-period returns when risk premiums are ignored.

Forward Rate Formula

fn = [(1 + yn)^n / (1 + yn-1)^(n-1)] - 1

• fn = Forward rate for year n

• yn = YTM on an n-year zero-coupon bond

• yn-1 = YTM on an (n−1)-year zero-coupon bond

Liquidity Preference Theory

Investors demand higher yields on long term bonds because they carry greater interest rate risk and offer less liquidity.

Liquidity Premium

Extra compensation investors demand for holding longer-term bonds because of their greater price risk and lower liquidity.

Liquidity Premium Formula

Forward Rate = Expected Future Short-Term Rate + Liquidity Premium

fn = E(rn) + LP

What is the main difference between Expectations Theory and Liquidity Preference Theory?

• Expectations Theory: Forward rates reflect only expected future short-term interest rates.

• Liquidity Preference Theory: Forward rates reflect expected future short-term rates plus a liquidity premium.