chapter 7: learning objectives term structure of interest rates
DESCRIPTION
Chapter 7: Learning Objectives Term Structure of Interest Rates expectations & other hypotheses real interest rate considerationsTRANSCRIPT
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
Long-term and short-term Government of Canada Bond Yields
0
4
8
12
16
20
24
60 65 70 75 80 85 90 95 00
Long-term yield
Short-term yield
Perce
nt pe
r yea
r
Year
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?
R1 R2
E11
The Key Relations in the Expectations Hypothesis
The Simplest case: R2 = (R1 + E11)/2
The General case: Rn = (R1 + E11 + E2
1 + … + En-11)/n
The Expectations Hypothesis: Two Examples
R2 5=(4+6)/2R1 4 14E1
1 6 13E1
2 12.5E1
3 12E1
4 11.5R5 12.6=(14+13
+12.5+12+11.5)/5
Hypothetical Yield Curves
Term
Yield
Rising
Constant
Falling
Financial Focus 7.1
Hypothetical YC are an estimate of the relationship between yield and term to maturity
Term
Yield
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
Term
Yield
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
Term
Yield
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
(1)Decades
(2)1 to 3 Years
(3)3 to 5 Years
(4)5 to 10 Years
(5)10 Year and Longer
(6)% of Quarters Spread is
Positive1960’s 0.513 0.877 1.090 1.255 92.51970’s 0.442 0.766 1.046 1.531 90.01980’s 0.044 0.096 0.184 0.455 65.01990’s 0.544 0.876 1.212 1.606 87.0
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
Shifting Yield Curves
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
Yield Curves and Monetary Policy
Figure 7.4: Shifting yield curves
Figure 7.5: The yield spread and recessions in Canada
-4
-3
-2
-1
0
1
2
3
4
5
1960 1965 1970 1975 1980 1985 1990 1995 2000
Yield
Spr
ead
Year
POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves
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
Competing Explanations of the Term Structure
The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner
LIQUIDITY PREMIUM
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
MARKET SEGMENTATION
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
3
4
5
6
7
8
0
4
8
12
16
20
1980 1985 1990 1995 2000
Aver
age m
atur
ity
Year
Treasury bill
Long term bonds
Averagematurityof debt
Percent per year
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