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LECTURE 3 OUTLINE YIELD CURVE DEFINITON FORWARD RATE DEFINITION CONSTRUCTION OF A YIELD CURVE LOANABLE FUNDS THEORY ARBITRAGE PRICING THEORY UTILITY BASED THEORIES: THEORIES OF THE TERM STRUCTURE OF INTEREST RATES (Unbiased Expectations Theory, Liquidity Preference Theory, Market Segmentation Theory) YIELD CURVE --Market prices of bonds will be determined by investor trading activity. --There are differences in investor preferences (some are long-term and some are short- term investors) and in the risk characteristics of different bonds (depending on duration). --Therefore, there’s no reason why market yields on instruments of different duration or maturity must be the same. --THE CONFIGURATION OF YIELDS FOR DIFFERENT MATURITIES IS REFERRED TO AS THE YIELD CURVE (=TERM STRUCTURE OF INTEREST RATES). Term structure of interest rates: Comparison of market yields on securities, assuming all characteristics (no default or liquidity risk) except maturity are the same. --The yield curve takes on different shapes at different times due to different economic reasons. (Check out the www.econbrowser.com website for more on yield curve.) --Note: There’s no unique relationship between yield and maturity date for coupon- bearing bonds, since they can differ in terms of coupon rate or principal repayment pattern. FORWARD RATES --Yield curve is determined by the market’s current expectations of future short term interest rates . --A forward rate is an expected or implied rate (quoted today) on a short-term security that is to be originated at some point in the future. 1
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--Market’s expectations of forward rates can be derived directly from existing or actual rates on securities currently traded in the spot market. Calculating the forward rate: --Assemble zero-coupon yields for a variety of maturities. --Suppose we have the yields y y y n 1 2 , , . . . . . . . , for zero-coupon bonds (or T-bills) with maturities of 1,2,…. .,n periods. These yields are referred to as spot rates . --We can then define forward rates using these spot rates. --A two-period loan can be thought as a one-period loan made now at the going one- period rate plus a forward one-period loan made one period from now at a forward rate. --A forward rate that’s implicit in a two-period spot rate can be defined as:
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This note was uploaded on 11/18/2011 for the course FIN 353 taught by Professor Cobus during the Fall '08 term at S.F. State.

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