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Chapter 7: Learning Objectives. Term Structure of Interest Rates. Chapter 7: Learning Objectives. Term Structure of Interest Rates expectations & other hypotheses. Chapter 7: Learning Objectives. Term Structure of Interest Rates expectations & other hypotheses
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Chapter 7:Learning Objectives • Term Structure of Interest Rates
Chapter 7:Learning Objectives • Term Structure of Interest Rates • expectations & other hypotheses
Chapter 7:Learning Objectives • Term Structure of Interest Rates • expectations & other hypotheses • real interest rate considerations
Chapter 7:Learning Objectives • Term Structure of Interest Rates • expectations & other hypotheses • real interest rate considerations • Anomalies in the yield curve
The Term Structure of Interest Rates: The Expectations Hypothesis • Why hold short-term vs. Long-term bonds? • Should their yields be linked to each other? E11 R1 R2
The Key Relations in the Expectations Hypothesis The Simplest case: R2 = (R1 + E11)/2 The General case: Rn = (R1 + E11 + E21 + … + En-11)/n
Hypothetical Yield Curves Yield Rising Constant Falling Term
Financial Focus 7.1 • Hypothetical YC are an estimate of the relationship between yield and term to maturity Yield Term
Financial Focus 7.1 • Hypothetical YC are an estimate of the relationship between yield and term to maturity • Yield curves must be constructed for similar types of financial instruments Yield Term
Financial Focus 7.1 • Hypothetical YC are an estimate of the relationship between yield and term to maturity • Yield curves must be constructed for similar types of financial instruments • One must not read too much into the shape/slope of a yield curve Yield Term
Yield Curve Puzzles • The Yield curve is generally upward sloping
Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive
Table 7.3: Yield differential relative to 90-day treasury bills
Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive • The yield curve tends to shift over time
Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive • The yield curve tends to shift over time • Figure 7.3 shows that inflation tends to shift the entire yield curve
Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive • The yield curve tends to shift over time • Figure 7.3 shows that inflation tends to shift the entire yield curve • The slope of the yield curve tends to predict future economic activity
POINT: COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant Empirical evidence for EH weakest for US POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant Empirical evidence for EH weakest for US Ignores many other factors that determine yields over time POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
Competing Explanations of the Term Structure • The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner
Competing Explanations of the Term Structure • The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner • The Market Segmentation theory: Short-term and long-term markets are separate
Competing Explanations of the Term Structure • The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner • The Market Segmentation theory: Short-term and long-term markets are separate • The Preferred-Habitat theory: there is limited substitutability between short-term and long-term bonds
Figure 7.7: Interest rates and the maturity structure of government of Canada debt
Summary • The term structure of interest rates explains why interest rates differ when their term to maturity differs
Summary • The term structure of interest rates explains why interest rates differ when their term to maturity differs • The expectations hypothesis predicts that long term rates are averages of expected short-term rates
Summary • The term structure of interest rates explains why interest rates differ when their term to maturity differs • The expectations hypothesis predicts that long term rates are averages of expected short-term rates • Despite the appeal of the expectations hypothesis there are “puzzles” in the behaviour of the yield curve