342 Chapter 12
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Transcript of 342 Chapter 12
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Chapter 12. The Term Structureof Interest RatesThe Yield CurveSpot and forward ratesTheories of the Term Structure
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Term structurebonds with the same characteristics,but different maturitiesfocus on Treasury yieldssame default risk, tax treatmentsimilar liquiditymany choices of maturity
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Treasury securitiesTbills: 4, 13, 26, and 52 weekszero couponTnotes:2, 5, and 10 yearsTbonds:30 years (not since 2001)Tnotes and Tbonds are coupon
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Treasury yields over time
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relationship between yield & maturity is NOT constantsometimes short-term yields are highest,most of the time long-term yields are highest
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I. The Yield Curveplot of maturity vs. yieldslope of curve indicates relationship between maturity and yieldthe living yield curve
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upward slopingyields rise w/ maturity (common)July 1992, currently
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downward sloping (inverted)yield falls w/ maturity (rare)April 1980
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flatyields similar for all maturitiesJune 2000
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humped intermediate yields are highestMay 2000
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Theories of the term structureexplain relationship between yield and maturitywhat does the yield curve tell us?
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The Pure Expectations TheoryAssume:bond buyers do not have any preference about maturityi.e.bonds of different maturities are perfect substitutes
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LT = long-termST = short-term
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if assumption is true,then investors care only about expected returnif expect better return from ST bonds, only hold ST bondsif expect better return from LT bonds, only hold LT bonds
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but investors hold both ST and LT bondsso,must EXPECT similar return:LT yields = average of the expectedST yields
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under exp. theory,slope of yield curve tells us direction of expected future ST rates
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why?if expect ST rates to RISE,then average of ST rates will be >current ST rateso LT rates > ST ratesso yield curve SLOPES UP
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ST rates expected to rise
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if expect ST rates to FALL,then average of ST rates will be ST yieldsor yield curve slopes up.
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ProblemHow do we interpret yield curve?slope due to 2 things:(1) exp. about future ST rates(2) size of liquidity premiumdo not know size of liq. prem.
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if liquidity premium is small,then ST rates are expected to rise
yield curvesmall liquidity premium
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if liquidity premium is larger,then ST rates are expected to stay the same
yield curvelarge liquidity premium
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Preferred Habitat Theoryassume:bonds of different maturities are imperfect substitutes,and investor preference for ST bonds OR LT bonds is not constant
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liquidity premium could be positive or negativeyield curve very difficult to interpretdo not know size or sign of liquidity premium
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Segmented Markets Theoryassume:bonds of different maturities are NOT substitutes at all
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if assumption is true,separate markets for ST and LT bondsslope of yield curves tells us nothing about future ST ratesunrealistic to assume NO substitution bet. ST and LT bonds
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unrealistic to assume NO substitution