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21-Liquidity Preference and Duration

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

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Liquidity Preference Theory

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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
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

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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
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

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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.
Should you Be Indifferent? View#2 Suppose that in 1 year, you may need to bail You need to liquidate and get cash.

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

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