These future interest rates are called forward rates

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Unformatted text preview: that the market expects interest rates to rise in the future – it depends on the liquidity premium. In Summary: Shape and Level of Yield Curve is determined by both liquidity premiums and market expectations: upward sloping yield curve does not mean the market expects interest rates to rise Preference – Investors will demand a premium for the risk associated with long-term bonds Risk Averse Investors - return must compensate for risk Upward Bias of Yield Curve - built into the long-term rates because of the risk premium Forward rates(what the term structure tells us) contain a liquidity premium and are not equal to expected future short-term rates (essentially the expected YTM, which will be used to calculate the expected price) 7 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 M ARKET SEGMENTATION THEORY The Market Segmentation Theory asserts that the shape of the yield curve is normally upward sloping. It is not related to market expectations of future interest rates. MST argues that there is excessive demand for short term bonds by households who have spare money to invest. There is also excessive supply of long term bonds by corporations who wish to borrow over a longer horizon. This causes the cost of money (YTM on short term bonds) to be lower than the cost of money over the long term (YTM on long term bonds). Hence the yield curve is the imbalance in supply and demand in each of the 2 segments that determines the shape of the yield curve. I NTERPRETING THE TERM STRUCTURE If the yield curve is to rise as the bonds move to longer maturities: A longer maturity results in the inclusion of a new forward rate that is higher than the average of the previously observed rates Reason: o Higher expectations for forward rates (ET) o Or Liquidity premium (LPT) o Or imbalance between long & short term supply and demand (MST) 8 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 L ECTURE 3 – D URATION I NTEREST RATE RISKS For fixed interest securities investments, there is an uncertainty in returns which is broadly known as Interest Rate Risks. There are 2 types of...
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