13. Long-Term Interest Rates: Bonds and the Expectations Theory Flashcards
What are the 3 characteristics that affect interest rates on debt instruments (are financial assets that represent a legal obligation for the issuer (borrower) to repay a certain amount of money to the holder (lender or investor) over time, typically with interest)?
- Maturity: How much does the borrower have to pay back?
- Risk: Some types of debts (e.g. government bonds in certain countries) have very little risk of default.
Others (mortgages, credit cards, corporate bonds) differ in the probability of default and in how much the lender will lose if there is a default - Liquidity - Debt instruments differ in how easily they can be traded. A bond for which a liquid market does not exist will probably have to pay out a higher interest rate to attract investors
What is the definition of a bond
Bonds are a form of IOU (I owe you) issued by governments or corporations to people who provide them with money
What is the principal of a bond?
A sum of money an investor agrees to provide the bond issuer
What are coupon payments?
a schedule for potential interest payments to be made
What is the definition of yield to maturity?
is the total return an investor can expect to earn if they hold a bond until it matures, assuming that all coupon payments are made on time and reinvested at the same rate
What is the relationship between bond prices and bond yields
Bond prices and bond yields move in the opposite direction.
The relationship between bond prices and bond yields is inverse: when bond prices go up, bond yields go down, and vice versa. This inverse relationship is central to understanding how bond markets work and is driven by the fixed nature of bond coupon payments and changing market interest rates.
How are coupon-paying bonds priced?
by viewing these bonds simply as a series of zero-coupon bonds bundled together
What is meant by the term structure?
The term structure of interest rates reflects the relationship between bond yields and maturities.
it is represented by the yield curve
Basic facts about movements in short and long-term interest rates
Bond Market Stylized Facts:
1. Rates on longer-term bonds are usually higher than shorter-term bonds (i.e.)
Definition of the expectations theory
The idea that yields differ so as to make each investment strategy equally attractive
- assumes you can’t increase your expected return by investing at a different interest rate
What the expectations theory explains and what it doesn’t
- Long rates depend on current and expected future short rates, so if short rates are trending in one direction, we would expect long rates to also go in that direction: This explains why rates often move together.
- But longer rates depend on expected short rates that may be far in the future. Today’s developments may have little effect on these expectations: Explains why long rates move less than short rates.
- If people expect a recession, they will expect the central bank to cut interest rate. This can make long-term rates go down even if short-term rates have not yet been cut. This explain why the shape of the yield curve tends to change dramatically around recessions.
However, the theory does not explain why yield curve usually slopes up: We cannot always be expecting short rates to rise.
What is forward guidance?
central banks giving the public guidance on what they plan to do in the future
Why does forward guidance by central banks influence long-term interest rates?
it shapes market expectations about future short-term interest rates, which in turn, affects the yields on long-term bonds
What is the maturity of a bond?
the length of time until the principal is repaid
What is a zero-coupon bond?
A bond that only pays out when it matures in a specified number of years
- It doesn’t make interest coupon payments along the way
