ECON 311 1nd Edition Lecture 8 Outline of Last Lecture I. The Risk Structure of Interest RatesOutline of Current Lecture I. The Term Structure of Interest RatesCurrent LectureChapter 5: The Risk and Term Structure of InterestI. Term Structure of Interest Ratesa. Yield Curve graph of the term structure ofInterest Ratesi. Only compare bonds of the sametypes (everything is the sameexcept for the maturity) with ayield curveii. Shows the relationship betweenYTM for a particular type of bondand the term to maturity of thosebondsb. Term Structure Observationsi. Interest rates for bonds withdifferent maturities tend to movetogether1. Short and long term ratestend to move in the samedirection)a. Typically the whole curve movesii. Yield Curves tend to be upward sloping when short-term rates are low and slope down when short – term rates are highiii. Yield curves are typically upward slopingc. Three Theories of the Term Structure of Interest Ratesi. Expectations TheoryThese 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. MaturityYield to Maturity 3 yr. 5 yr. 10 yr.Assumes: Bond Investors view bonds of different maturities as perfect substitutes (expected returns would be the same)EX: Option 1: buy 2 year bondOption 2: buy 1 year bond and in 1 year reinvest the proceeds in another 1 year bondExpected Return Option 1 = i2t = today’s 2 year bond yieldExpected Return Option 2 = i1 t+i1 t +12 = today’s 1 year bond plus the epected return of next years bond yieldsThis assumption implies that: i2t=i1 t+i1 t +121. The yield on long – term bonds is the average of the current and expected future yields on short term bonds2. People expect the return on investment to go up in the future so the higher the maturity the higher the yield3. Explains Observations #1 and #2 but not
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