TSIR: Hick's Theory (liqudity theory)

Question 1

What is Hick’s theory?

Answer 1

Borrowers prefer to borrow long (for investment purposes) and lenders prefer to lend short, therefore the LT rate equals the avg. of expected future ST rates plus a term premium (p)

Question 2

What is the equation for Hick’s theory?

Answer 2

See printed notes

Question 3

Explain the rationale for Hick’s theory?

Answer 3

Risk averse agents (assumption) want to minimise risk. Lending presents liquidity risk, which increases when the maturity of a bond is longer. Therefore, lenders need to be offered additional return to be induced into lending long

Question 4

Two reasons the liquidity risk rises for bonds with longer maturities?

Answer 4

1) Will be longer until the maturity payment for cash is paid
2) Often harder to sell a LT bond for above reason

Question 5

Implication of Hick’s theory?

Answer 5

LT rates often higher than ST rates, which explains why observed yield curves are often UWS! Yield cuvre will only be DWS if a significant fall in ST rates is expected

Question 6

Explain 2 criticisms of Hick’s theory?

Answer 6

1) Borrowers do not always want to borrow long (eg. credit card to be repaid at end of month)
2) Lenders do not always want to lend short; some lenders want a LT stream of income (eg. pensioners buying bonds)

Question 7

Evaluate the criticism that ‘lenders do not always want to lend short, some may want a LT stream of income’?

Answer 7

Hick’s theory ignores inflation risk! There is a risk that inflation may erode the return on the bonds, for example if the nominal return is below that of inflation. Therefore, by buying many consecutive short term bonds this allows people to earn a steady stream of income, and reduce the risk that they are stuck with a bond paying less than the inflation rate (therefore making losses due to inflation risk)

Question 8

3 main conclusion topics for macro policy if Hick’s theory holds?

Answer 8

1) Effect on LT rates of change in ST rates largely depends on if expectations of future short rates are changed
2) Quantitative easing
3) Deficit reduction policies

Question 9

Explain the implications on quantitative easing if Hick’s theory holds?

Answer 9

QE is when the BofE buys large quantities of LT gov./other bonds, which raises their price. This is equivalent to a reduction in the interest rate, and a reduction in the term premium, without changing ST rates. Therefore, if Hick’s hypothesis holds, then QE can affect the LT rate because it affects the term premium.

Question 10

What are the assumptions behind Hick’s theory?

Answer 10

1) Risk-averseness
2) identical bonds except for maturities (ie. tax treatments, risk levels, transaction costs) (this is for EH too!) (finish!)