Econ week 6

pure expectancy theory

The ONLY thing that affects the shape of the yield curve in this theory is the outlook for future interest rates relative to current rates. Nothing else matters.

This Liquidity premium theory explains the overwhelming prevalence of upward-sloping yield curves.

Hence, even if investors expect short-term rates to remain the same in the future as they are today, the yield curve will be upward sloping. This explains

Segmented market theory NO INFLUENCE supply and demand

Hence, in this theory, expectations have _____ on the shape of the yield curve. Its shape simply depends on _____ for various maturities, which in turn are determined by institutional considerations just discussed.

The term structure of interest rates fact 2, default risk, marketability, taxability

Hence, one can examine the term structure of U.S. Treasury securities, which are similar in ___ ____, _____, etc. by examining yields on a given day on various maturities--- for example, 90-day T bills, 1-year T notes 2- year T notes, 5-year T notes, 10-year T bonds, 20-year T bonds, and 30-year T bonds.

near peak levels actively pushing up short-term yields.

Hence, the inverted or downward-sloping yield curve often occurs just before the peak of the business cycle, when yields in general are____, and the Federal Reserve has been _____ In fact, an inverted yield curve is regarded as a harbinger of recession. Many analysts view an inverted yield curve as forecasting recession.

Flat: a horizontal line Ascending (upward sloping) Arched upward sloping line Descending(downward sloping) arched downward sloping line Humped, starts going up then goes super arched line going down

Historically, four different shapes of yield curves have existed: draw them and compare to slide 5

Segmented market theory move in the same

But this theory cannot come to grips with the fact that yields of various maturities tend strongly to ____ direction over time-when short-term yields are rising, long-term yields are also typically rising. This fact suggests that there is a lot of substitutability among different maturities by investors.

problems with segmented market theory

But this theory cannot come to grips with the fact that yields of various maturities tend strongly to move in the same direction over time-when short-term yields are rising, long-term yields are also typically rising. This fact suggests that there is a lot of substitutability among different maturities by investors.

ascending or upward sloping 95 98

By far the most common shape of the yield curve is ____ ----In the U.S. the yield curve has been ____about ___ percent of the days in the past 80 years and ____ percent of the days in the past 40 years.

logic of this equation sqr root to the n of ((1 + R2)2 = (1 + R1) ( 1 + t + 1 r1 ))-1

If people believe they would have a larger principal at the end of the investment horizon by purchasing short-term securities and rolling them over, people would buy short-term and sell their long-term bonds. This behavior would reduce short-term rates and boost long-term rates until the two sides of the equation came into balance.

push up short-term yields and push down long-term yields.

If there is a widespread expectation that yields (short-term and long-term) will be lower in the future, people would sell their short-term T bills and purchase long-term bonds to lock in good rates while they can........This would _____ This sometimes creates an inverted (downward-sloping) yield curve.

Proof by contradiction (1 + R2)2 = (1 + R1) ( 1 + t + 1 r1 ) sell buy down up

If there were a widespread belief that buying the 2-year bond would provide a better return than buying and rolling over 1-year bonds, then people would ___ their 1-year bonds and ____ 2-year bonds. This action would push ____ the price (raise the yield) on 1-year bonds and push ____ the price (reduce the yield) on 2-year bonds until the 2 sides of the equation were equal (that is, until expected returns from the two strategies were the same).

avoid buying

If you are a optimist, you should ____ these bonds—because an optimist expects robust future economic activity and likely expects inflation to move somewhat higher than the current 1.5 % per year, both of which imply higher bond yields and thus lower bond prices in the not-distant future.

low not fall slowly

If you are a pessimist about the prospects for the U.S. economy, you would think long-term bonds are still a good investment at 2.25 percent (on the 10-year Treasury bond) because you think the U.S. economy will grow very ____, inflation and bond yields will remain ___, and bond prices will __

Pure expectancy theory fact 2

In this theory, an upward-sloping yield curve implies people expect short-term yields to be rising in the future. A downward-sloping (inverted) yield curve implies a consensus that short-term yields will be falling in the future.

Segmented Markets Theory------

In this theory, financial institutions have an overwhelming preference for a particular maturity. They are locked into a particular maturity. The various maturities are "segmented" off from each other. There is no scope for substitution across maturities in response to expected yield advantages.

inverted, The spread in the figure is negative Recession

In those few periods in which the T bill yield exceeds the T bond yield, the yield curve is ___(though slightly so). . Note that this tends to occur just prior to the peak of the business cycle, before a __ occurs.

the peak of the business cycle, before a recession occurs.

In those few periods in which the T bill yield exceeds the T bond yield, the yield curve is inverted (though slightly so). The spread in the figure is negative. Note that this tends to occur just prior to _____

Liquidity Premium Theory a higher yield risker

Investors are typically risk averse, and to compensate them for risk, they must receive ____to induce them to take on additional risk. Hence, there must be a term premium in long-term bonds to induce investors to buy them (because long-term bonds are ___ than short-term bonds).

segmented market theory fact 2

Its shape simply depends on supply and demand for various maturities, which in turn are determined by institutional considerations just discussed.

assumtions to the pure expectancy theorem 4

Large numbers of investors form expectations about future interest rates and act aggressively on these expectations.

(1 + R2)2 = (1 + R1) ( 1 + t + 1 r1 )

Let R2 be the yield today on a 2-year bond, R`1 be the yield today on a 1-year bond, and t+1 r1 be the yield you currently expect to exist one year from now on a one-year bond. Then it must be true that This equation states that the investors in the marketplace expect to earn the same return over the 2-year period whether one buys a 2-year bond and holds it for 2 years or buys a one-year bond and reinvests the proceeds a year later in a one-year bond at the rate (yield) currently expected to prevail a year from now.

"Reversion to the Mean Phenomenon"-------

Many people have a notion of a "normal" level of interest rates. When interest rates are exceptionally high relative to this normal level, people expect rates to fall in the future. When rates are exceptionally low relative to the normal, people expect rates to move higher in the future. what is this called

sharply higher

Note that when the 10-year T bond yield is ____ than the T bill yield, this means that the yield curve is steeply ascending

more strongly pro-cyclical greater

Recall that interest rates are strongly pro-cyclical-they rise during economic expansions and fall during recessions. And short-term rates are _______ than long-term rates. Short-term yields exhibit _____ amplitude of fluctuation.

pure expectations theory

The ______ is inconsistent with predominant existence of upward-sloping yield curves. It cannot explain that fact.

assumtions to the pure expectancy theorem 3

There are no transactions costs in buying and selling securities. Investors will therefore swap maturities if they deem it advantageous in terms of maximizing expected returns over the investment horizon.

Liquidity Premium Theory------

This theory accepts the pure expectations theory with ONE QUALIFICATION: Long-term bonds have more market risk than short-term bonds.

Pure Expectations Theory—

This theory asserts that the yield on a long-term bond is the average of the current short-term yield and future short-term yields currently expected to prevail over the life of the long-term bond.

preferred habitat theory

This theory can account for ALL the facts about yield curves, unlike the other theories. It acknowledges that expectations, market risk, and institutional factors all play a significant role in determining the shape of the yield curve.

Preferred Habitat Theory----

This theory combines elements of the other 3 theories. It states that various institutions do indeed have preferred maturities (preferred habitats), but they will deviate from these preferred maturities to some extent if the perceived additional returns for doing so are sufficiently large.

segmented market theory

This theory is the polar opposite of the pure expectations theory. Hence, in this theory, expectations have NO INFLUENCE on the shape of the yield curve.

1.02 2.27 risen fallen

Today, the yield curve has become flatter. On 9/21/2017 the 90-day Tbill was at ____ percent and the 10-year bond yield was ___ percent. Short-term rates have ___ while long-term rates have ___ since February 15, 2017. On September 21, the spread was 1.25 percentage points.

"yield curve.", yield

When shown as a graph, the term structure is known as the ________ This snapshot of ____ on differing maturities changes EVERY DAY.

lower in the future (reversion to the mean) below

When yields in general and short-term yields in particular are unusually high, a consensus typically prevails that these yields will move _____ and this causes long-term yields to drop ____short-term yields as people seek to lock in the attractive long-term yields while they can by purchasing long-term bonds.

upward sloping cyclical expansion inverted

Yield curve exhibits a consistent cyclical pattern. It is strongly ______ at the trough (low point) of the business cycle and becomes flatter during the ____ and is sometimes ____at the peak of the cycle.

upward-sloping downward segmented markets theory.

Yield curve is ____ when yields in general are quite low (as in recent years), and often ______ sloping when yields in general are very high. This is consistent with all theories except the ______

facts about yield curve upward sloping pure expectations liquidity premium theory.

Yield curve is predominantly _____. This is NOT consistent with the _____ theory but is consistent with the _____

segmented markets theory.

Yields of different maturities typically move in the same direction most of the time. This is consistent with all theories except the _____

The term structure of interest rates definition:

is a snapshot of yields prevailing at a given point in time on securities of different maturities, but which are very similar in all regards (default risk, tax treatment, etc.) other than length of time to maturity.

assumtions to the pure expectancy theorem 1 and 2

the only objective of investors is to maximize returns over their investment horizon. Investors therefore have no inherent preference for any particular maturity.

In the liquidity premium theory, (TP) Look on slide 18 for formula

the yield on a long-term bond will be the geometric mean of the current and expected future short-term yields + a premium to compensate the lender for additional risk in the long-term bonds. The size of this term premium ___ fluctuates over time as market volatility and perceptions of risk change.

Segmented Markets Theory------I

this theory, financial institutions have an overwhelming preference for a particular maturity. They are locked into a particular maturity. The various maturities are "segmented" off from each other. There is no scope for substitution across maturities in response to expected yield advantages.