Term
| How can bonds with identical risk, liquidity, and taxation differ? |
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Definition
| because the time remaining to maturity is different |
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Term
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Definition
| a graph of the yield on bonds with same risk, liquidity and tax consideration as a function of maturity |
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Term
| What does an upward sloping yield curve mean? |
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Definition
| long-term rates are above short-term rates |
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Term
| What does a flat yield curve show? |
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Definition
| short- and long-term rates are the same |
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Term
| What does an inverted yield curve show? |
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Definition
| long-term rates are below short-term rates |
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Term
| 3 facts that the theory of term structure of interest rates must explain |
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Definition
1. Interest rates on bonds of different maturities move together over time
-- This is not a one-for-one relationship, but often the whole yield curve will shift up or down.
2. When short-term rates are low, the yield curve tends to slope upward. Inverted yield curves often occur when short rates are high.
3. The norm is an upward-sloping yield curve. Flat or inverted yield curves are uncommon. |
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Term
| Three Theories to Explain the 3 facts |
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Definition
1. Expectations theory explains the first two facts but not the third
2. Segmented markets theory explains fact three but not the first two
3. Liquidity premium theory combines the two theories to explain all three facts |
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Term
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Definition
Long-term rates represent expectation of short-term rates over the life of the long-term bond.
If market expect short rates to remain at 5% for the next 10 years, then a 10-year bond should offer 5%, in this case (abstracting from transaction costs) and investor would be indifferent between holding the 5% 10-year bond or rolling over a sequence of 5% 1-year bonds.
That indifference implies that bond holders consider bonds of different maturities as perfect substitutes |
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Term
| How does the Expectations Theory correspond with the 3 facts? |
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Definition
Explains why interest rates on bonds with different maturities move together over time (fact 1)
Explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2)
Cannot explain why yield curves usually slope upward (fact 3) |
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Term
| How does the Expectations Theory Explain Fact 1? |
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Definition
1. If it goes up today, iet+1, iet+2 etc. goes up (equals) average of future rates goes up (equals) int goes up
2. Therefore: it int , i.e., short and long rates move together |
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Term
| How does the expectations theory explain Fact 2? |
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Definition
When short rates are low for whatever reason (e.g., monetary policy is loose), they are expected to rise to normal level, and long rate = average of future short rates will be above today’s short rate: yield curve will have (+) slope
2. When short rates are high, they will be expected to fall in future (perhaps, for example, a recession is on the horizon, and the Fed will aggressively lower short rates to combat it), and long rate will be below current short rate: yield curve will have (-) slope |
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Term
| What is the key assumption in the segmented markets theory? |
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Definition
| Bonds of different maturities are not substitutes at all. Investors have exceedingly strong preferences for holding bonds of a certain maturity |
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Term
| The implication of segmented markets theory |
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Definition
| Markets are segmented or separate: interest rate at each maturity is determined separately by the demand for and supply of that bond. In other words, each point on the yield curve is the result of supply and demand for that maturity, with no interactions between markets for different maturities. |
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Term
| How does the segmented markets explain fact 3? |
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Definition
| If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3) |
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Term
| What is the key assumption of the liquidity premium theory- Preferred Habit Theory |
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Definition
| Bonds of different maturities are partial (but not perfect) substitutes. |
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Term
| What is the implication of the liquidity premium theory? |
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Definition
| It allows for certain maturity preferences but assumes that investors have some willingness to shift between maturities. Modifies Expectations Theory with features of Segmented Markets Theory. |
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