ECON 311 1nd Edition Lecture 8 Outline of Last Lecture I The Risk Structure of Interest Rates Outline of Current Lecture I The Term Structure of Interest Rates Current Lecture Chapter 5 The Risk and Term Structure of Interest Yield to Maturity I 3 yr Term Structure of Interest Rates a Yield Curve graph of the term structure of Interest Rates i Only compare bonds of the same types everything is the same except for the maturity with a yield curve ii Shows the relationship between YTM for a particular type of bond and the term to maturity of those bonds b Term Structure Observations i Interest rates for bonds with different maturities tend to move together 1 Short and long term rates tend to move in the same direction a Typically the whole curve moves ii Yield Curves tend to be upward sloping when short term rates are low and slope down when short term rates are high iii Yield curves are typically upward sloping c Three Theories of the Term Structure of Interest Rates i Expectations Theory 5 yr 10 yr Maturity These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Assumes Bond Investors view bonds of different maturities as perfect substitutes expected returns would be the same EX Option 1 buy 2 year bond Option 2 buy 1 year bond and in 1 year reinvest the proceeds in another 1 year bond Expected Return Option 1 i2t today s 2 year bond yield Expected Return Option 2 i 1 t i 1 t 1 2 today s 1 year bond plus the epected return of next years bond yields This assumption implies that i 2t i1 t i 1 t 1 2 1 The yield on long term bonds is the average of the current and expected future yields on short term bonds 2 People expect the return on investment to go up in the future so the higher the maturity the higher the yield 3 Explains Observations 1 and 2 but not 3