ECON 311 1nd Edition Lecture 9 Outline of Last Lecture I The Term Structure of Interest Rates Outline of Current Lecture I The Term Structure of Interest Rates II Bond Investing Strategy III Yield Curves and Expected Inflation Current Lecture Chapter 5 The Risk and Term Structure of Interest I Term Structure of Interest Rates a Three Theories of the Term Structure of Interest Rates i Expectations Theory Assumes Bond Investors view bonds of different maturities as perfect substitutes expected returns would be the same This Theory implies that i 2t i1 t i 1 t 1 2 and so on ii Segmented Markets Theory Assumes Bond investors don t consider bonds of different maturities to be substitutes at all there is a separate market for bonds of each maturity and the expected return on bonds of one maturity has no effect on the demand for bonds of other maturities Also bond investors tend to prefer shorter maturities so shorter term yields are typically lower than long term yields Explains observation 3 yield curves are usually upward sloping iii Liquidity Premium Theory Assumes Bonds of different maturities ARE substitutes BUT NOT perfect substitutes AND investors prefer short term bonds to long term bonds 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 i t i et 1 i et 2 i et n 1 i nt l nt n Liquidity Premium lnt Maturity Liquidity Premium Theory Formula Segmented Markets So lnt increases with n The longer the maturity the bigger the liquidity premium YTM 5 Expectations Theory EX Assume 1 year bond yields 5 and are expected to remain there forever Why are 2 year bond rates higher than 1 year bond rates II III People expect interest rates to increase and People prefer short term bonds Bond Investing Strategy a To take on an extra year of maturity you need to be offered at least 20 basis points higher Shifting Maturities Strategy i Basis points are a tenth of a percent ii Liquidity premium based on this strategy is ALWAYS 2 1 Ignores that the liquidity premium increases over time Yield Curves and Expected Inflation Expected Inflation ie And increase in expected inflation shifts the yield curve up The nominal interest rate real interest YTM rate ie a Yield Curve Shapes and their meanings Maturity YTM YTM YTM Maturity Maturity Yield Curve ie is expected to fall Inverted ie is expected to fall a bit Maturity Maturity rise a bit to rise expected to ie ie isis expected Inverted Yield Curves predict recessions within about a year o Short term end of the curve is determined by the Federal Government and the long term end is determined by the bond market Credit shrinks when an inverted yield curve occurs which halts economic activity