FIN2700 Final by january - Chapter 6 The Term Structure and...

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Chapter 6 The Term Structure and Risk Structure of Interest Rates The Term Structure of Interest Rates The term structure of interest rates is the relationship at any given time between the length of time to maturity and the yield on a debt security. The yield curve graphically depicts the term structure of interest rates. The length of time to maturity is on the horizontal axis and the yield on the vertical axis. Each point on a curve corresponds to the yield on a given day of a particular type of bond for a particular maturity date. Term structure exists for different types of debt instruments usually bonds US Treasuries Corporate Bonds State and Local Bonds The yield curve is typically ascending, but can be flat, descending, or humped. Theories of Term Structure The pure expectations theory The liquidity premium theory The segmented markets theory The preferred habitat theory Pure Expectations Theory Market forces dictate that the yield on a long-term bond of any particular maturity equals the geometric mean (or average) of the current short-term yield and successive future short-term yields currently expected to prevail over the life of the long-term security. If transactions costs are zero, the investor would expect to earn the same average return over the long run if they: purchase a long-term bond and hold it to maturity or purchase a short-term bond and "roll it over" every time it matures. Assumptions of the Pure Expectations Theory
Investors seek to maximize holding period returns--the returns earned over their relevant planning horizons. Investors have no institutional preference for maturities. They regard various maturities as perfect substitutes for each other. There are no transactions costs associated with buying and selling securities. Hence, investors will always swap maturities to respond to perceived yield advantages. Large numbers of investors form expectations about the future course of interest rates, and act aggressively on those expectations. Implications of the Pure Expectations Theory If investors believe that short-term interest rates will be higher in the future, the yield curve today slopes upward. If investors think interest rates will decline in the future, the yield curve is downward sloping or inverted. In the pure expectations theory: an ascending yield curve is evidence of market consensus that interest rates are headed upward; a downward-sloping or inverted yield curve implies that economic agents expect that interest rates are headed lower, and a flat yield curve implies a consensus that future yields will remain the same as current yields. In the pure expectations theory, nothing except the outlook for interest rates affects the shape of the yield curve.

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