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Unformatted text preview: CHAPTER 15: THE TERM STRUCTURE OF INTEREST RATES 1. Expectations hypothesis: The yields on long-term bonds are geometric averages of present and expected future short rates. An upward sloping curve is explained by expected future short rates being higher than the current short rate. A downward- sloping yield curve implies expected future short rates are lower than the current short rate. Thus bonds of different maturities have different yields if expectations of future short rates are different from the current short rate. Liquidity preference hypothesis: Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk. Thus bonds of different maturities can have different yields even if expected future short rates are all equal to the current short rate. An upward sloping yield curve can be consistent even with expectations of falling short rates if liquidity premiums are high enough. If, however, the yield curve is downward sloping and liquidity premiums are assumed to be positive, then we can conclude that future short rates are expected to be lower than the current short rate. 2. d. 3. In general, the forward rate can be viewed as the sum of the markets expectation of the future short rate plus a potential risk or liquidity premium. According to the expectations theory of the term structure of interest rates, the liquidity premium is zero so that the forward rate is equal to the markets expectation of the future short rate. Therefore, the markets expectation of future short rates (i.e., forward rates) can be derived from the yield curve, and there is no risk premium for longer maturities. The liquidity preference theory, on the other hand, specifies that the liquidity premium is positive so that the forward rate is less than the markets expectation of the future short rate. This could result in an upward sloping term structure even if the market does not anticipate an increase in interest rates. T he liquidity preference theory is based on the assumption that the financial markets are dominated by short- term investors who demand a premium in order to be induced to invest in long maturity securities. 4. True. Under the expectations hypothesis, there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future. 15-1 5. Uncertain. Expectations of lower inflation will usually lead to lower nominal interest rates. Nevertheless, if the liquidity premium is sufficiently great, long-term yields may exceed short-term yields despite expectations of falling short rates....
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- Spring '08