All three theories of term structure have merit from

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Unformatted text preview: loping. The opposite occurs for high short-term rates and low long-term rates. All three theories of term structure have merit. From them we can conclude that at any time, the slope of the yield curve is affected by (1) inflationary expectations, (2) liquidity preferences, and (3) the comparative equilibrium of supply and demand in the short- and long-term market segments. Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter-maturity loans, and greater supply of short-term loans than of long-term loans relative to demand. The opposite behaviors would result in a downwardsloping yield curve. At any time, the interaction of these three forces determines the prevailing slope of the yield curve. Risk Premiums: Issuer and Issue Characteristics So far we have considered only risk-free U.S. Treasury securities. We now reintroduce the risk premium and assess it in view of risky non-Treasury issues. Recall Equation 6.1: k1 k* IP RP1 risk-free risk rate, RF premium In words, the nominal rate of interest for security 1 (k1) is equal to the risk-free rate, consisting of the real rate of interest (k*) plus the inflation expectation premium (IP) plus the risk premium (RP1). The risk premium varies with specific issuer and issue characteristics; it causes similar-maturity securities8 to have differing nominal rates of interest. 8 EXAMPLE The nominal interest rates on a number of classes of long-term securities on March 15, 2002, were as follows:910 Security U.S. Treasury bonds (average) Nominal interest 5.68% Corporate bonds (by ratings): High quality (Aaa–Aa) 6.13 Medium quality (A–Baa) 7.14 Speculative (Ba–C) 8.11 Utility bonds (average rating) 6.99 8. To provide for the same risk-free rate of interest, k* IP, it is necessary to assume equal maturities. When we do so, the inflationary expectations premium, IP, and therefore RF , will be held constant, and the issuer and issue characteristics premium, RP, becomes the key factor...
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This document was uploaded on 01/19/2014.

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