Topic 5 - Theories of interest rates

• Yield curve

  Graphic representation of the relationship between the yield of bonds of the same credit quality but different maturity

  
• Treasury yield curve


  • Treasury securities are free of default risk and differences in creditworthiness do not affect yield estimates
  • Treasury market is very liquid
• The traditionally constructed Treasury yield curve is an unsatisfactory measure of the relation between required yield and maturity

  
• Pricing a bond

  1. Calculate the present value of its cash flows

  2. Use the yield on a Treasury security with the same maturity as the bond plus an appropriate risk premium or spread
• There is a problem with using the Treasury yield curve to determine the appropriate yield at which to discount the cash flow of a bond
• The value of a bond should equal the value of all the component zero-coupon instruments
• Determinants of the shape of the term structure

  • Expectations theory
  • Liquidity theory
  • Preferred-habitat theory
  • Market-segmentation theory
• Forward rates


  The yield on a six-month Treasury bill that will be purchased six months from now
• Calculating forward rates

  Use the spot rates of one-year and six-month Treasury bills
• Pure Expectations Theory

  The interest rate on a long-term bond equals the average of short rates expected to occur over life of the long-term bond
• According to the pure expectations theory, the forward rates exclusively represent expected future rates
• Expectation of rising short-term future rates

  Leads to a rising yield curve
• The Pure Expectations Theory does not account for the risks inherent in investing in bonds
• Risks in bond investing

  • Uncertainty about the price of the bond at the end of the investment horizon
  • Uncertainty about the rate at which the proceeds from a bond that matures during the investment horizon can be reinvested (reinvestment risk)
• The Pure Expectations Theory does not explain why yield curves almost always slope upward
• Liquidity Premium Theory

  Bondholders face both inflation and interest-rate risk, which increases with the term of the bond. Investors require compensation for this increased risk.
• Preferred Habitat Theory

  Investors have a preference for bonds of one maturity over another and will only buy bonds of different maturities if they earn a higher expected return
• Segmented Markets Theory


  Bonds of different maturities are not substitutes at all, and the interest rate for each bond is determined by the demand for and supply of that bond