Chapter 12. The Term Structureof Interest Rates.ppt

Chapter 12. The Term Structureof Interest Rates The Yield Curve Spot and forward rates Theories of the Term Structure Term structure bonds with the same characteristics, but different maturities focus on Treasury yields same default risk, tax treatment similar liquidity many choices of maturity Treasury securities Tbills: 4, 13, 26, and 52 weeks zero coupon Tnotes: 2, 5, and 10 years Tbonds: 30 years (not since 2001) Tnotes and Tbonds are coupon Treasury yields over time relationship between yield maturity is NOT constant sometimes short-term yields are highest, most of the time long-term yields are highest I. The Yield Curve plot of maturity vs. yield slope of curve indicates relationship between maturity and yield the living yield curve upward sloping yields rise w/ maturity (common) July 1992, currently downward sloping (inverted) yield falls w/ maturity (rare) April 1980 flat yields similar for all maturities June 2000 humped intermediate yields are highest May 2000 Theories of the term structure explain relationship between yield and maturity what does the yield curve tell us? The Pure Expectations Theory Assume: bond buyers do not have any preference about maturity i.e. bonds of different maturities are perfect substitutes LT = long-term ST = short-term if assumption is true, then investors care only about expected return if expect better return from ST bonds, only hold ST bonds if expect better return from LT bonds, only hold LT bonds but investors hold both ST and LT bonds so, must EXPECT similar return: LT yields = average of the expected ST 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 rate so LT rates ST rates so yield curve SLOPES UP ST rates expected to rise if expect ST rates to FALL, then average of ST rates will be current ST rate so LT rates ST rates so yield curve slopes DOWN ST rates expected