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Unformatted text preview: THE TERM STRUCTURE OF INTEREST RATES Topics 1. Term structure. 2. Facts about term structure. 3. Theories of the Term Structure: Expectation hypothesis theory. Segmented Markets theory Liquidity Premium theory Formula for yields Yield on discount bond of maturity m: m t m t m j P ) 1 ( 1 , , + = t=date. m=maturity. j ,t = yield to maturity at t on bond that pays out m,t at t+m. P m,t = price at t on bond that pays out at t+m. Term structure and yield curve Fix a date t. Then, there is a group of different discount bonds with different maturities. They all have different yields: j 1,t , j 2,t , j 3,t etc. This pattern of yields is called the term structure. Its graph is called the yield curve. Term Structure: The Facts Fact 1 : Short and long yields tend to move together over time Fact 2 : Yields on short term bonds are more volatile than yields on longterm bonds. act 3 The yield curve is almost always Fact 3 : The yield curve is almost always sloping upwards. Long vs. Short Term Yields 8 2 14 16 18 6 8 10 12 (% p.a.) 10 yr 1 yr 2 4 r b c t g n r b c t 1 9 5 3 A p r 1 9 5 9 F e b 1 9 6 4 D e c 1 9 7 O c t 1 9 7 6 A u g 1 9 8 2 J u n 1 9 8 8 A p r 1 9 9 4 F e b 1 9 9 9 D e c 2 5 O c t n example of 3 Today's ield An example of 3: Today s yield curve. Some algebra background:...
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 Spring '11
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