Chapter 3 Martellini Lecture

# Chapter 3 Martellini Lecture - CHAPTER 3 MARTELLINI, et....

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CHAPTER 3 MARTELLINI, et. al. EMPIRICAL PROPERTIES and CLASSICAL THEORIES of the TERM STRUCTURE DEFINITION AND PROPERTIES OF THE TERM STRUCTURE The term structure of interest rates, also known as the yield curve, is the graphing of interest rates corresponding to their respective maturity. Term structure of interest rates is the series of interest rates set to term to maturity, or when the instrument matures, at a given time. The nature of interest rates determines the nature of the term structure. There can be different types of yield curves depending on the interest rates. See Figure 3.1 on page 64. It’s possible that can have forward yield curve that starts in year 1 with an upward slope. The other curves are inverted over the short term (until the 1 year maturity). The difference between the swap curve and the par curve is the term structure of the yield spreads between the interbank loan market and the T-bond market. Like the zero coupon yield curve from the 1 year maturity onwards, the 1 year forward yield curve is strictly upward sloping. The slope steepens at the 8 year maturity because the zero coupon yield curve starts to slope upwards in the same maturity band. The slope of the instantaneous forward yield curve is even more pronounced, for the same reasons. WHAT KIND OF SHAPE CAN IT TAKE? Yield curve = at any point in time, the relationship between the debt’s remaining time to maturity and its yield to maturity is represented by the yield curve. Is a graph of the relationship between the debt’s remaining time to maturity (X axis) and its yield to maturity (Y axis). It shows the pattern of annual returns on debts of equal quality and different maturities. Graphically depicts the term structure of interest rates.

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Three possible curves: 1. Quasi-flat or Flat (See Figure 3.2) = a yield curve that reflects relatively similar borrowing costs for both short and longer term loans 2. Increasing or Normal (See Figure 3.3) = an upward sloping yield curve that indicates generally cheaper short term borrowing costs than long term borrowing costs. Is the norm re: rates. 3. Decreasing or Abnormal or Inverted (See Figure 3.4) = a downward sloping yield curve that indicates generally cheaper long term borrowing costs than short term borrowing costs. Historically is the exception. 4. Humped = See Figure 3.5 for decreasing on the short end and then increasing OR See Figure 3.6 for increasing on the short end, and then decreasing HOW DOES IT EVOLVE OVER TIME? Key points to keep in mind: Interest rates are not negative Interest rates are affected by mean reversion effects Changes of interest rates are not perfectly correlated The volatility of short term rates is higher than the volatility of long term rates Three main factors explain more than 95% of the changes in the yield curve Interest rates are not negative: While real interest rates may become negative, generally where inflation is rising

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## This note was uploaded on 04/07/2012 for the course ECONOMICS 101 taught by Professor Tillet during the Spring '12 term at Broward College.

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Chapter 3 Martellini Lecture - CHAPTER 3 MARTELLINI, et....

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