21-Liquidity Preference and Duration

21-Liquidity Preference and Duration - Liquidity Preference...

Info iconThis preview shows pages 1–8. Sign up to view the full content.

View Full Document Right Arrow Icon
Liquidity Preference Theory
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Expectations Theory Review Given that 1-year spot rate currently is 10% YTM 1t =10% Market expects 1-yr spot rate next year to be 12% E[YTM 1t+1 ]=12% Expectations Theory: % 11 ) ( rate spot yr - 2 ) 1 ( ) 12 . 1 )( 10 . 1 ( year next rate spot expected 2 2 2 2 = + = = t t YTM YTM f
Background image of page 2
Expectations Theory Review The yield curve is usually upward sloping. According to Expectations Theory: The market usually expects interest rates to increase. But interest rates can’t increase more often than they decrease. They’d drift off to infinity and beyond
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Should You Be Indifferent? Expectations theory is based on the idea that the market is indifferent between buying short-term bonds and rolling them over, and buying long-term bonds. Is one strategy more risky than the other? If so, then these strategies should have different expected returns, or, in other words: ] [ 1 1 2 + t YTM E f
Background image of page 4
Should you be Indifferent? Assume: Strategy 1: buy 1 year bond, then roll over into another 1 year bond. Price of 1 year bond: 1000/1.10=909.09 E[R 1 ]=(1.10)(1.12)=1.232 Strategy 2: buy 2 year bond Price of 2 year bond: 1000/(1.11) 2 =811.62 E[R 2 ]=(1.11) 2 =1.232 % 11 % 12 ] E[ % 10 2 1 1 1 = = = + t t t YTM YTM YTM
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Should you Be Indifferent? View#1 You’re locked in to get the return with the two year bond There is uncertainty regarding the actual return you’ll get by buying the one year bond and rolling it over. Perhaps buying the one-year bond is perceived as more risky than just locking in and buying the two-year bond.
Background image of page 6
Suppose that in 1 year, you may need to bail You need to liquidate and get cash. What do you get back from each strategy?
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 33

21-Liquidity Preference and Duration - Liquidity Preference...

This preview shows document pages 1 - 8. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online