Lecture 6

Question 1

What is the typical structure of a yield curve

Answer 1

It is almost never flat, usually it slopes gradually upwards as maturity increases

Question 2

Is there a simple explanation for the typical shape of the yield curve or term structure of interest rates

And if so, can you name three

Answer 2

Expectations Hypothesis

Liquidity Preference explanation

Market segmentation & preferred habitat explanations

Question 3

What are the assumptions of the expectations hypothesis

Answer 3

Long term and short term securities are perfect substiuttes

Securities are free of default risk

Individuals are risk neutral

Question 4

What is the expectations hypothesis

Answer 4

Implied forward rate is equal to the market’s consensus expectation
of future short-term (spot) interest rate.

The implied forward rate f_{1,2} (implied rate for money loaned for 1
year, one year from now) is, according to the expectations
hypothesis, exactly equal to the market’s expectation of what the
1-year spot rate will be next year.

Question 5

Within the expectation hypothesis how are long term interest rates determined

Answer 5

Determined by market expectations of future short-term interest rates

Expectations account for shape of term structure

Question 6

What does an upward sloping yield curve say within the expectation hypothesis

Answer 6

investors anticipate increases in
short-term interest rates. Future short-term rates are expected to be
higher than current short-term rates.

Question 7

What does an downward sloping yield curve say within the expectation hypothesis

Answer 7

Downward sloping yield curve ) Future short-term rates are

expected to be lower than current short-term rates.

Question 8

Regarding uncertatinty, what is needed for the expectation hypothesis to hold

Answer 8

No uncertainty

Question 9

If there is uncertainty what will be higher, the two year zero coupon rate squared or the one year zero coupon rate multiplied with the expectation of tomorrow’s one period zero coupon rate

Answer 9

The latter one

Question 10

Proof that the Expectation Hypothesis does not hold under uncertainty

Answer 10

Lecture 6 Script Page 9

Question 11

What is the Liquidity Preference

Answer 11

Often enlisted to help explain a curious & persistent phenomenon:
historically, term structure has had an upward slope more often
than a flat or downward slope.

Market participants are assumed to risk averse. Hypothesis asserts
that investors prefer short-term fixed income securities over
long-term securities; prefer their funds to be liquid rather than
“tied-up” in long-term security.

Question 12

Within the Liquidity Preference Hypothesis: are long-term or short term securities regarded as riskier

Answer 12

Long-term securities are viewed as being riskier; investors will
demand a premium (liquidity premium) for this risk associated with
the longer-term security

Question 13

Within the Liquidity Preference Hypothesis: How are long-term rates determined

Answer 13

Long term rates are determined by market expectations of future
short term interest rates, plus a liquidity premium applicable to the
term and liquidity of the investment.

Question 14

Within the Liquidity Preference Hypothesis: what upward bias has the yield curve in comparison to the expectation hypothesis

Answer 14

Liquidity Premium

Question 15

Within the Liquidity Preference Hypothesis: What is higher - the forward in period 1 for one period or the expectation of future short term interest rate also for one period

Answer 15

The forward rate, because it contains a liquidity premium

Question 16

What is the market segmentation hypothesis

Answer 16

Assert that the market for fixed income securities is segmented by
maturity dates. Short and long-term securities are traded in distinct
markets.

Market participants prefer to stay in distinct maturity segments of
the market: some institutional investors such as commercial banks
prefer to invest in short-term & liquid securities while others such
as insurance companies and pension funds prefer the longer end of
the market.

Question 17

In which hypothesis model are short term and long term interest rates allowed to move independently

Answer 17

Market segmentation hypothesis

Observed rates are not directly influenced by expectations. Short
and long-term rates may move independently

Question 18

What is the preferred habitat model

Answer 18

It represents a combination of expectations and market participants maturity preferences

Market interest rates of securities with different maturities reflect
average short-term interest rates expected to prevail over the life of
the long-term security, plus a term premium that arises from market
participants’ preferences to participate in one maturity segment of
the market or another.

Question 19

Within the Market segmentation hypothesis : how is the term structure determined

Answer 19

Short term and long term securities are traded in two different markets

Trading in these distinct maturity segments determines the various
spot rates (ie the forces of supply & demand) in its own market
segment. Term structure is determined by equilibrium rates set in
the various maturity markets.

Question 20

Why do we observe changes in the shape of the term structure in the preferred habitat model

Answer 20

Changes in shape of the term structure may reflect either changes in
expectations of short-term interest rates or changes in the term
premia arising from demand and supply.

Question 21

What are the two puzzles of the espinoza and dimitri paper

Answer 21

Puzzle 1: Upward Term Structure

Puzzle 2: Flattening Term Structure

Question 22

Elaborating a little more about the first puzzle: What is mean with Upward Term Structure

Answer 22

The term structure is upward sloping although spot interest rates
have been historically stable

Question 23

What are explanations of the first puzzle

Answer 23

1. Risk premium
2. Liquidity
3. Preferred Habitat
4. Representative Agent Model with Transaction Technology

Question 24

What is the second puzzle about the flattening term struture

Answer 24

The term structure has been flattening in the recent years (Bummer)

Question 25

What are explanations for the second puzzle

Answer 25

1. Better anchored inflation
2. Reduction in the volatility of real activity
3. Increased preference for long-term bonds (changes in regulations,
   prospect of pension fund reforms)
4. Increased demand from growing countries with high savings rate
5. Lower supply of long-term bonds due to changes in environment
   (particularly the Treasury’s decision to stop issuing 30-year bonds
6. Demographical changes, etc.