TSIR: expectations hypothesis Flashcards
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Question: why might a 3-yr Treasury Bill have a different interest rate to a 30yr Treasury Bond?
What is the TSIR?
The (TSIR) refers to the way interest rates, and therefore yields, vary on bonds (and other securities) with different term to maturities (but identical in other aspects, eg. Risk, tax treatments, transaction costs).
What does the yield curve show? Draw it.
It shows the prevailing current interest rates on bonds of different maturities; it is plotted with maturity (x-axis) against yield (y-axis)
What shape is the yield curve?
Typically, UWS, but can also be flat/DWS
5 reasons it is important to study the TSIR?
1) Household decisions for saving/choosing mortgages
2) Influences how MP affects the economy (how ST rates affect LT rates)
3) Gov. can lower cost of servicing debt (if right mix of LT and ST bonds)
4) Slope yield curve may give info on future inflation
5) DWS yield curve argued to be good recession predictor
Saving, MP, Servicing, Future inflation, Recession predictor
SMSFR
Define TSIR?
suppose Ri is the yield on a pure discount bond (one-time payment @ maturity) with maturity i, and i ranges from 1-T, then TSIR is given by: R1,R2,…,RT
What is the expectations hypothesis?
- Long term rates are the average of current and expected future ST rates over the period to maturity
Use example to explain the expectations hypothesis?
- Eg. If can choose between: a) 2-1yr bonds, current rate=10%, expected rate t+1=12%, or b) a 2-yr bond, would probably need roughly 11% rate on the 2-yr bond to be inclined to go for it.
Rationale for the expectations hypothesis?
if relationship stated did not hold then risk-neutral agents would invest in the bonds which generates the highest expected return over the period in question, and in doing so would force expected returns on the different bonds into equality with each other (arbitrage)
General (approximate) formulae for expectations hypothesis?
see printed notes
What is the main implication of the expectations hypothesis?
The effect on LT rates of the CB changing ST rates will largely depend on how expectations of future ST rates are affected. Therefore, expectations of future CB behaviour are crucial in determining LT rates and TSIR.
If expectations aren’t changed (EH), then how much will LT rate change by when the ST rate changes?
R(01)/T
Why does the expectation hypothesis seem implausible alone?
because the yield curve is often UWS. If the hypothesis held, we would expect there not be such a bias for UWS yield curve.
What is likely to be the main reason the expectations hypothesis would fail? Why?
Majority of risk-averse attitudes in agents; (ie. Risk-averse tf preference for liquidity when lending, otherwise would arbitrage). Risk aversion will affect TSIR if it affects people’s choice between ST and LT bonds.
