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1. Pure Expectations Theory 1. Pure Expectations Theory yield on a long-term bond equals the geometric mean (or Option 1: Invest in 1-year bond and roll-over average) of the current short-term yield and successive 0 1 2 0i1 = 4% future short-term yields. 1i2 = 8% 0i1 = 4% 1i2 = 8% If transactions costs are zero, the investor would expect to earn the same average return over the long run if they: Option 2: Invest in 2-year bond 1. purchase a short-term bond & "roll it over" every time 0 1 2 0i2 = 6% it matures. 2. purchase a long-term bond & hold it to maturity 0i2 = 6% 7 8 Pure Expectations Theory: Implications Pure Expectations Theory: Implications If investors believe that short-term interest rates will If investors think interest rates will decline in the be higher in the future, the yield curve today slopes future, the yield curve is downward. upward.Interest rate (%) Interest rate (%) Maturity (Years) Maturity (Years) 9 10 Pure Expectations Theory: Implications 2. Liquidity Premium Theory In the pure expectations theory: The issue: long-term bonds entail greater market risk than an ascending yield curve is evidence of market that short-term securities do. interest rates are rising a downward-sloping or inverted yield curve implies that Market risk is the risk of fluctuation in the price of the market expects that interest rates are falling security due to interest rate changes. a flat yield curve implies a consensus that future yields will remain the same as current yields Investors may have to sell their assets prior to maturity, In the pure expectations theory, nothing except the outlook exposing themselves to the possibility of losses as interest for interest rates affects the shape of the yield curve. rates & thus market prices change. 11 12 2
2. Liquidity Premium Theory If bond buyers are risk averse, they must be compensated with a term premium for the greater market risk inherent in long-term bonds. tRL = tRL-1 + TP The Liquidity Premium Theory states that the term premium (TP) is positive & increases with the length of term, so the normal yield structure is ascending (Upward sloping). Bond with longer maturity provides higher yield 13 14 3. Segmented Markets Theory 3. Segmented Markets TheoryInterest rates depend on supply and demand in each market For Lenders (Supply):Short term interest rates Long term interest rates Short term securities Long term securities provide depend on depend on provide liquidity & stability stability of income (i.e. coupon of principal (price bond)1. Short-term supply for fund stability) 1. Long-term supply for fund(Short-term lenders) (Long-term lenders) Lenders who prefer income Lenders who prefer stability over principal stability protection of principal will will prefer to invest in Long2. Short-term demand for fund 2. Long-term demand for fund prefer to invest in Short(Short-term borrowers) term securities (T-Bonds) (Long-term borrowers) term securities (T-Bills) 15 16 3. Segmented Markets Theory Segmented Markets Theory: ImplicationsFor borrowers: Individuals & firms are strongly motivated to Yields in any maturity sector are determined strictly by supply match the maturities of their assets with the maturities of & demand in that sector their liabilities Corporate & U.S. Treasury debt management decisions Firms borrowing to finance Families buying homes prefer significantly influence the shape of the yield curve. inventories prefer short- long-term fixed rate If firms & the government are currently issuing mortgages term loans predominantly long-term debt the yield curve will be relatively steep. Municipalities & corporations Banks need liquidity investing in long-term capital If they are issuing short-term debt short-term yields will prefer to invest short-term projects borrow long-term be high relative to long-term yields. 17 18 3
Segmented Markets Theory: Implications 4. Preferred Habitat Theory Treasury debt management is a potential tool of economic This hybrid theory combines elements of the other three. policy because it can influence the yield curve. Borrowers & lenders do hold strong preferences for particular maturities.Gov. wants to raise Short term yield & reduce Long term yield The yield curve will not conform strictly to the predictions ofGov. will issue only Short term debt the other three theories. higher demand If expected additional returns to be gained by deviating higher Short term yield from their preferred maturities become large enough, Twisting the yield curve institutions will deviate from their preferred maturities. 19 20 4. Preferred Habitat Theory The Risk Structure Of Interest Rates Institutions will accept additional risk in return for A security issuer defaults if it fails to meet the terms of the additional expected returns. contractual agreement (indenture) in full. For a bond, default is either the borrowers failure to make full Institutions change from their preferred maturities or interest payments or to redeem at face value habitats if expected additional returns from other maturities are large enough. Embedded in the yields of risky securities is a premium to Example (p. 133): banks shift to invest in L-T securities compensate lenders for default risk if L-T securities provide large additional return (yield) 21 22 Risk Premiums Risk Premiums Moodys and Standard and Poors, provide ratings of the quality of bonds in the United States Risk premium = risky yield – risk free yield (ranging from investment grade bonds to junk bonds) Issuers (Borrowers) Credit Rating Interest rate Risk premiums increases during recessions & other Government AAA 4% times when firms experience financial distress. Good quality Company AA 6% --- --- -- It decreased modestly during the economic boom. --- --- -- Bad credit company D 10% 23 24 4