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P0 1 1 1 c coupon r required rate of return

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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 years’ time. 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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