bonds 3 - Liquidity Preference : The premise is that...

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Yield Curve - Term Structure 3 governing hypotheses concerning the shape of the yield curve; Expectations Hypothesis : i.e., Assume we expect an increasing interest rate given a present flat term structure 1. Demand to buy LT bonds will decrease, since a rising rate implies a decreasing price. Funds will switch to ST, creating an excess demand for ST, and investors will wait for higher yields. 2. Speculators will sell bonds where they expect prices to fall -- LT, buy back at later date to cover -- creating an excess supply of LT bonds, investing the proceeds in ST obligations creating an excess demand for ST. 3. Borrowers will borrow LT funds now, creating an excess supply of LT funds. If there exists an excess supply of LT and excess demand for ST, then LT yields will rise relative to ST yields, upward sloping as expected.
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Unformatted text preview: Liquidity Preference : The premise is that investors will want to be compensated for holding any LT instruments. The longer the term to maturity, the more the inherent risk. Therefore, forward short rates will not be true predictors of future short rates due to a built in holding premium. Market Segmentation : A rising yield curve should only exist if all borrowers want to borrow LT, and investors want to buy ST to keep liquid. But, there are demand and supply conditions in the market that force some lenders and borrowers to shift their preferences. Banks must insure that the short/medium term demand deposits are not covered with locked in LT investments. Immunization -- holding periods are governed by the nature of the liabilities, and not necessarily the rates offered (incentives will have to be given to force the switch)....
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