Chapter 12. The Term Structureof Interest RatesThe Yield CurveSpot and forward ratesTheories of the Term Structure

Term structurebonds with the same characteristics,but different maturitiesfocus on Treasury yieldssame default risk, tax treatmentsimilar liquiditymany choices of maturity

Treasury securitiesTbills: 4, 13, 26, and 52 weekszero couponTnotes:2, 5, and 10 yearsTbonds:30 years (not since 2001)Tnotes and Tbonds are coupon

Treasury yields over time

relationship between yield & maturity is NOT constantsometimes short-term yields are highest,most of the time long-term yields are highest

I. The Yield Curveplot of maturity vs. yieldslope of curve indicates relationship between maturity and yieldthe living yield curve

upward slopingyields rise w/ maturity (common)July 1992, currently

downward sloping (inverted)yield falls w/ maturity (rare)April 1980

flatyields similar for all maturitiesJune 2000

humped intermediate yields are highestMay 2000

Theories of the term structureexplain relationship between yield and maturitywhat does the yield curve tell us?

The Pure Expectations TheoryAssume:bond buyers do not have any preference about maturityi.e.bonds of different maturities are perfect substitutes

LT = long-termST = short-term

if assumption is true,then investors care only about expected returnif expect better return from ST bonds, only hold ST bondsif expect better return from LT bonds, only hold LT bonds

but investors hold both ST and LT bondsso,must EXPECT similar return:LT yields = average of the expectedST yields

under exp. theory,slope of yield curve tells us direction of expected future ST rates

why?if expect ST rates to RISE,then average of ST rates will be >current ST rateso LT rates > ST ratesso yield curve SLOPES UP

ST rates expected to rise

if expect ST rates to FALL,then average of ST rates will be ST yieldsor yield curve slopes up.

ProblemHow do we interpret yield curve?slope due to 2 things:(1) exp. about future ST rates(2) size of liquidity premiumdo not know size of liq. prem.

if liquidity premium is small,then ST rates are expected to rise

yield curvesmall liquidity premium

if liquidity premium is larger,then ST rates are expected to stay the same

yield curvelarge liquidity premium

Preferred Habitat Theoryassume:bonds of different maturities are imperfect substitutes,and investor preference for ST bonds OR LT bonds is not constant

liquidity premium could be positive or negativeyield curve very difficult to interpretdo not know size or sign of liquidity premium

Segmented Markets Theoryassume:bonds of different maturities are NOT substitutes at all

if assumption is true,separate markets for ST and LT bondsslope of yield curves tells us nothing about future ST ratesunrealistic to assume NO substitution bet. ST and LT bonds

unrealistic to assume NO substitution