78106_05_Web_Ch05D_p01-04

78106_05_Web_Ch05D_p01-04 - WEB EXTENSION 5D The Pure...

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W E B E X T E N S I O N 5D The Pure Expectations Theory and Estimation of Forward Rates I n Chapter 5, we saw that the shape of the yield curve depends primarily on two factors: (1) expectations about future inflation and (2) the relative risk of securities with different maturities. We also saw how to calculate the yield curve, given in- flation and maturity-related risks. In practice, this process often works in reverse: In- vestors and analysts plot the yield curve and then use information embedded in it to estimate the market s expectations regarding future inflation and risk. This process of using the yield curve to estimate future expected interest rates is straightforward, provided (1) we focus on Treasury bonds, and (2) we assume that all Treasury bonds have the same risk (in other words, there is no maturity risk premium). Although this second assumption may not be reasonable, it enables us for the time be- ing to take out the effects of risk and focus exclusively on how expectations about fu- ture interest rates affect the shape of the yield curve. Later on, we will show what happens when we once again assume that there is a maturity risk premium. In fact, even though most evidence suggests that there is a positive maturity risk premium, some academics and practitioners contend that this second assumption is reasonable, at least as an approximation. They argue that the market is dominated by large bond traders who buy and sell securities of different maturities each day, that these traders focus only on short-term returns, and that they are not concerned with maturity risk. According to this view, a bond trader is just as willing to buy a 20-year bond to pick up a short-term profit as to buy a 3-month security. Strict pro- ponents of this view argue that the shape of the Treasury yield curve is therefore de- termined only by market expectations about future interest rates. This position has been called the pure expectations theory of the term structure of interest rates. The pure expectations theory (often simply referred to as the expectations the- ory ) assumes that (1) bond traders establish bond prices and interest rates strictly on the basis of expectations for future interest rates, and (2) they are indifferent to ma- turity because they do not view long-term bonds as being riskier than short-term bonds. If this were true, then the maturity risk premium (MRP) would be zero, and
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