8.3) TSI theories

Question 1

Interpreting the shape of the curve means explaining why the ______ rates of different maturities are different.

Answer 1

spot

Question 2

What is a yield curve?

Answer 2

plot of spot rates of different maturities

Question 3

What are the theories of the term structure of interest rates? (4)

Answer 3

1) The Pure Expectations Theory (PET) (Under conditions of certainty: Same theory for forward rates)
2) Liquidity preference theory (LPT) (Under conditions of uncertainty- An extension of PET Theory (certainty))
3) Market Segmentation (Why spot rates and interest rates are different
4) Preferred Habitat (An extension of the MS)

Question 4

What assumptions does the The Pure Expectations Theory (PET) make? (2)

Answer 4

The PET theory makes two assumptions:
1) Assumes an environment of certainty, with no risk and zero liquidity premiums
AND
2) Forward rates (or expected future short rates) equal the market expectation of future interest rates, fn = E(rn)

Because they are derived from spot rates, which are current and prevailing yields

Question 5

What are the implications of assumption 1 ( an environment of certainty, with no risk and no liquidity premiums)? (2)

Answer 5

1) Spot rate: Is a geometric average of current and forward rates (future short rates)

2) The yield curve: Is determined solely by current rn and expected future short rates (forward rates)
(fn) fn can be viewed as a risk-free rate of return

Question 6

What are the implications of assumption 2 (says Forward rates = the market expectation of future interest rates) of the PET? (2)

Answer 6

• fn = E(rn)
• Meaning the yield curve is purely a function of market expectations of interest rates.

Question 7

When does the yield curve of a PET slope:
- Upwards
- Downwards
- constant

Answer 7

• When next year’s forward rate, f2, > this year’s spot rate, y1, the yield curve slopes up. (f2 >y1)
• When next year’s forward rate, f2, is less than this year’s spot rate, y1, the yield curve slopes (f2< y1)
  down.
• Forward rates (or expected future short rates) equal the market expectation of future interest rates, E(r2) = f2 the yield curve is constant

Question 8

What does an upward sloping yield curve mean?

Answer 8

Market is anticipating future short interest rates or future bond yields to increase in future.

Question 9

What does an downward-sloping yield curve mean?

Answer 9

Market is anticipating future short interest rates or future bond yields to decrease in future.

Question 10

What does a flat yeild curve mean?

Answer 10

Market anticipates future short-term rates will be mostly constant.

Question 11

According to the pure expectations theory what does a humped yield curve suggest about the expectations of future interest rates? (5marks)

Answer 11

“The market is anticipating future short rates to be higher over the medium-term period and to be lower in the longer-term period.

Question 12

Under the pure expectations hypothesis, if the yield curve is upward sloping, the market must expect an increase in short-term interest rates. True/false/uncertain? Why?

Answer 12

“True. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future. There are no risk premiums built into bond prices.”

Question 13

How do you determine the expected future short rate under the PET framework?

Answer 13

Question 14

What is the Liquidity Preference Theory (LPT)?

Answer 14

It’s an offshoot (extension) of the PET theory.

Question 15

What are the assumptions of the LPT? (2)

Answer 15

1) An environment of uncertainty, which means the prevalence of risk.
2) That the forward rate embodies the market’s expectation of future interest rates E(rn) and the liquidity risk premium. ; The fn = E(rn) ± liquidity premium

Question 16

What equation is the e(Rn) derived under for the PET theory?

Answer 16

Question 17

What are the implications of LPT assumption 1 (An environment of uncertainty, which means the prevalence of risk- bonds are no longer perfect substitutes)? (2)

Answer 17

• Short-term investors will demand a premium for the risk associated with long-term bonds (Long-term bonds are riskier)
• Long-term investors will demand a premium for the risk associated with short-term bonds (liquidity premium)

Question 18

What are the implications of assumption 2 (That the forward rate embodies the market’s expectation of future interest rates E(rn) and the liquidity risk premium)? (2)

Answer 18

• Spot rates are determined by fn [from the PET, now E(rn)] and an adjustment of the liquidity premium adjustment.
• Yield curve is determined by fn [from the PET, = E(rn)] and an adjustment of the liquidity premium adjustment

Shape of yield curve is purely a function of forward rates & liquidity premium

Question 19

What is the implication of the risk assumptions of LPT?

Answer 19

The implication of the risk assumptions is that investors demand a liquidity risk premium to invest in bonds that are outside their preferred investment horizons

Question 20

What does an upward sloping curve imply on the LPT theory? (3)

Answer 20

1) The market is expecting future interest rates to rise + rising liquidity premium demanded by
short-term investors. [market is dominated by short term investors]
2) The market is expecting future interest rates to be constant + rising liquidity premium demanded by short-term investors.
3) The market is expecting future interest rates to fall + rising liquidity premium. The rate at which they are slowing in terms of interest rates is smaller than the rate at which the liquidity premium is increasing.

Question 21

What does a downward sloping curve imply? (3)

Answer 21

1) The market is expecting future interest rates to rise + decreasing liquidity premium demanded by long-term investors. [The market is dominated by long-term investors]
2) The market is expecting future interest rates to be constant + decreasing liquidity premium
demanded by long-term investors.
3) The market is expecting future interest rates to fall + rising liquidity premium (lower impact
than E(rn).
The rate at which they are slowing in terms of interest rates is greater than the rate at which the liquidity premium is increasing.

Question 22

Discuss whatever combination of E(rn) & LRP that gives you an upward/downward or flat sloping
curve (2x2)

Answer 22

Upward-sloping yield curve:
- Market expects that future interest rates will (1) rise, or (2) be flat, or (3) will fall, BUT liquidity premium increasing fast enough with maturity
- Market dominated by short-term investor

Downward-sloping yield curve:
- Market expects that future interest rates will (1) rise, or (2) be flat, or (3) will fall, BUT liquidity premium decreasing fast enough with maturity
- Market dominated by long-term investor

Question 23

What do advocates beleive in general? (3)

Answer 23

• Short-term investors dominate the market (generally speaking, the forward rate exceeds the expected short rate)
• Yield curve has an upward bias built into the long-term rates because of the risk premium (More short-term investors)
• General view, curve can take any shape though

Question 24

How do investors demand a liquidity premium? (2)

Answer 24

• Not a direct demand
• Implied by the outcome of the yields

Question 25

Compare teh PET theory to the LPT, by an upward sloping curve and a downward sloping curve? (2x2)

Answer 25

Question 26

How do short term investors or long-term investors demand a liquidity premium? (2)

Answer 26

• It is not a direct demand.
• It is implied by the outcome of the yields.

Question 27

What are the assumptions of Market segmentation theory (MST) ? (5)

Answer 27

• Yield curve shape is determined by supply and demand.
• Market is made up of segments short-term and long-term participants:
• No yield differential will induce them to change maturities.
• Supply and demand for Short-Term & Long-Term instruments is independent
• Yield curve is a function of demand and supply within segments

Question 28

Investors with short-term ________________ (e.g., banks, money market funds) invest in ______ term assets.

Investors with _________ -term liabilities (e.g., insurance companies) invest in longer-term ___________

Answer 28

liabilities
short
long
bonds

Question 29

What is the shape of the MST curve in a boom?

Answer 29

Question 30

What does the upward sloping MST curve imply? (1x2)

Answer 30

• Implies more demand for short-term instruments & less demand for long-term instruments
  ▪ Investors prefer their portfolios to be liquid, short-term rates are lower (higher demand)
  ▪ Explains fact that short-term interest rates are generally lower than long-term interest rates

Question 31

Expalin the shape of the MST curve in a recession

Answer 31

Question 32

What does a downward sloping MST yield curve imply? (1x2)

Answer 32

• Implies LESS demand for short-term instruments & MORE demand for long-term instruments
  ▪ Investors prefer their portfolios to be** less liquid, short-term rates are higher** (lower demand)
  ▪ Explains fact that short-term interest rates are generally higher than long-term interest rates