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Unformatted text preview: THEORY
The Expectations Theory asserts that forward rates are market expectations of future interest rates.
I.e. f(n,t) = E*r(n,t)+ For example, f(1,1) = E*r(1,1)+, means that the forward rate on a 1 year bond in 1 years’
time as implied by the term structure represents the market forecast of interest rate on the 1 year bond in 1
In a rational market, whereby market participants are hypothesised to consider all the relevant information
before making a forecast, today’s market expectations of future interest rates are unbiased estimates of actual
future interests observed t years later. The average forecast error (average difference between expected rate
and actual rate) should be zero under unbiased estimates.
In Summary: Observed long-term rate is a function of today’s short-term rate and expected future STerm rates
Shape and Level of Yield Curve are determined solely by market expectations of future interest
rates: If the yield curve is upward (downward) sloping, it means that market expects interest
rates to rise (fall) in the future
Perfect substitutes of ST and LT securities – investors who have an investment horizon of 1 year
are indifferent between holding bonds with 1, 2, or 3 years, since all alternative investments are
expected to generate the same HPR
Risk neutral investors – so they will judge their choices purely by level of expected return
Unbiased estimates – of actual future rates
Forward rates that are calculated from the yield on long-term securities are market consensus
expected future short-term rates
6 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 L IQUIDITY PREMIUM TH EORY
The Liquidity Premium Theory asserts that market participants are risk averse, as they will judge their choices
based on the level of expected risk and return, and risk = return. Lenders have ST investment horizons whilst
Borrowers have LT investment horizons. Long term investments are used to fund LT projects, which may not
generate sufficient cash flows to repay short term borrowings in the near future. If they issue short term
bonds, then they have to organise refinancing in the short term and will be subjected to uncertain...
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