Flashcards in Topic 5 – Term and Risk Structures of Interest Rates Deck (32)

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1

## Yield on bond

###
return on bond when the bond is held until maturity.

the total return on an investment, comprising interest received, and any capital gain (or loss).

2

## Interest rate (coupon rate)

### on bond to maturity is known when issued but yield on bond may not be known because it depends on future interest rates

3

## Bond sold before maturity date may incur

### capital gain or loss.

4

## Term Structure of Interest Rates

### The relationship between interest rates and terms to maturity for debt instruments in the same risk class

5

## Yield Curve

### is a graph, at a point in time, of yields on an identical security with different terms to maturity

6

## RISK STRUCTURE OF INTEREST RATES

### The relationship between interest rates and default risk for debt instruments in the same maturities

7

## There are four types of Yield Curves

###
Normal / Positive

Inverse / Negative

Humped

Flat

8

## Normal / Positive Yield Curve

###
Long-term interest rates are higher than short-term rates

Upward Sloping

9

## Inverse (Negative) Yield Curve

###
Long-term interest rates are lower than short-term rates

Downward Sloping

Possible in periods of tight liquidity or contractionary monetary policy

10

## Flat Yield Curve

### A flat yield curve means that the yield to maturity on all debt instruments (for example, govt securities) is the same.

11

## Humped Yield Curve

###
The shape of the yield curve changes over time from being a normal curve to being an inverse curve.

i - Short-term bond with lower interest rate (high demand for short-term bond);

ii - Medium-term bond with higher interest rate;

iii - Long-term bond with lower interest rate (higher demand for long-term bond).

12

## The fact that the shape of the yield curve changes over time suggests that

### monetary policy interest rate changes are not the only factor affecting interest rates.

13

## There are three theories that explain the term structure of interest rates

###
The Expectation Theory

The Segmented Markets Theory

The Liquidity Premium Theory

14

## Expectations Theory

### A theory that explains the shape of a yield curve through current and future short term interest rates.

15

## Assumptions of the Expectations Theory

###
1 - Large number of financial investors with homogenous expectations about future values of short term interest rates;

2 - No transaction costs;

3 - No impediments;

4 - Bonds with different maturities are PERFECT SUBSTITUTES.

16

## The Expectation Theory: Shapes of Yield Curves (normal_

### result from expectations that future short-term rates will be higher than current short-term rates.

17

## The Expectation Theory: Shapes of Yield Curves (inverse)

### Will result if the market expects future short-term rates to be lower than current short-term rates.

18

## The Expectation Theory: Shapes of Yield Curves (humped)

### Investors expect short-term rates to rise in the future but to fall in subsequent periods.

19

## The Segmented Markets Theory

### All bonds are not perfect substitutes; investor have preferences when investing in short or longer term bonds

20

## The Segmented Markets Theory (Assumptions)

###
1. Bonds of different maturities are not substitutes at all.

2. Bonds may only be substitutes within certain time frames

21

## How does the segmented markets theory reject the expectations theory

### Rejects the expectations theory assumption that all bonds are perfect substitutes, or that investors are indifferent between holding short-term and longer-term securities

22

## Implication of Segmented Markets Theory

###
Markets are completely segmented - Interest rate at each maturity are determined separately.

The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond with no effects from expected returns on other bonds with other maturities.

23

## Implication of Segmented Markets Theory Assumptions

###
- Investors have particular holding period in their mind.

- If they match the maturity of the bond to the desired holding period, they can obtain a certain return with reduced risk.

24

## Segmented Markets Theory: Yield Curve slopes up

### because demand for short-term (ST) bonds is relatively higher than long-term (LT) bonds

25

## Segmented Markets Theory: Yield Curve slopes down

### would indicate that the demand for LT bonds is relatively higher, thus lower yield.

26

##
Suppose the Central Bank sold Treasury bonds with one-year to maturity in the market.

What would be the outcome under this theory?

###
- The price of short-term bonds would decline and the yield curve would lift.

- Since short-term bonds are not substitutes of medium to long-term bonds, the yield of medium to long-term bonds will not be affected according to this theory.

27

## The Liquidity Premium Theory

### Investors prefer short term securities; investors prefer short term securities and therefore require compensation to invest longer term

28

## Liquidity Premium Theory Key Assumption

### Bonds of different maturities are substitutes, but are not perfect substitutes!

29

## Liquidity Premium Theory Implication

###
- Modifies Expectations Hypothesis with features of Segmented Markets Theory.

- Investors prefer short rather than long-term bonds and must be paid positive term premium, to hold long-term bonds.

30