53 the liquidity preference theory the liquidity

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The liquidity preference theory The liquidity preference theory Comment: although most pension funds are long-term investors, they are evaluated in the short run. So according to the liquidity preference theory liquidity preference theory to be willing to invest in long-term bonds to be willing to invest in long-term bonds investors require a risk premium. investors require a risk premium. 54
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The liquidity preference theory The liquidity preference theory So the following has to hold: so since it is always the case that Then according to the liquidity preference theory: 1 1 1 1 ] 1 [ 1 n n n n n n r r E r n n n n n n r r E r 1 ] 1 [ 1 1 1 1 n n n n n n r f r ) 1 ( ) 1 ( ) 1 ( 1 1 1 ) ( 1 1 n n n n r E f 55
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The liquidity preference theory The liquidity preference theory The difference is called a liquidity premium . In the market we can observe the prices of bonds with different maturities, calculate YTM and forward rates. The liquidity preference theory argues that forward rates are not a perfect measure for expected future interest rates because they are the sum of the expectations for the future interest rates and the liquidity premium. ) ( 1 1 n n n n r E f 1 1 1 ) 1 ( ) 1 ( ) 1 ( n n n n n n r r f premium Liquidity ) ( 1 1 n n n n r E f 56 56
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The liquidity preference theory The liquidity preference theory The liquidity preference will be higher when: 57
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The liquidity preference theory The liquidity preference theory Overall the prices of long term bonds (and consequently the long term interest rates) are affected by: Short term interest rates. Expected future short term interest rates. The risk premium. 58
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The yield curve The yield curve There are several possible shapes to the yield curve: increasing, decreasing, or flat. Sometimes it is non-monotonic. 59
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The yield curve The yield curve r T YTM 60
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Flat yield curve Flat yield curve R T Here the YTM is equal to the single interest rate and the single forward rate. 61
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A declining yield curve A declining yield curve R T YTM 62
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The yield curve The yield curve If the yield curve is increasing, what does it mean for expected future spot rates? A rising yield curve implies that the forward rates are higher than expected future spot rates: The meaning: either interest rates are expected to increase, or there is a high liquidity premium, or both. It is difficult to infer about the future interest rates. 1 2 1 2 1 1 2 1 2 2 2 1 1 2 1 r premium Liquidity ) ( then ) 1 ( 1 1 since ) 1 ( 1 if r E f r f r f r r r 63
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The yield curve The yield curve We can infer from a declining yield curve that interest rates are expected to decline: 1 2 1 2 1 1 2 1 2 2 2 1 1 2 1 r premium Liquidity ) ( then ) 1 ( 1 1 since ) 1 ( 1 if r E f r f r f r r r 64
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The yield curve The yield curve
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