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TAMU ECON 311 - Term Structure of Interest Rates and Yield Curves
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ECON 311 1nd Edition Lecture 9 Outline of Last Lecture I. The Term Structure of Interest RatesOutline of Current Lecture I. The Term Structure of Interest RatesII. Bond Investing StrategyIII. Yield Curves and Expected InflationCurrent LectureChapter 5: The Risk and Term Structure of InterestI. Term Structure of Interest Ratesa. Three Theories of the Term Structure of Interest Ratesi. Expectations TheoryAssumes: Bond Investors view bonds of different maturities as perfect substitutes (expected returns would be the same)This Theory implies that: i2t=i1 t+i1 t +12 and so onii. Segmented Markets TheoryAssumes: 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 toprefer shorter maturities, so shorter-term yields are typically lower than long-term yieldsExplains observation #3 (yield curves are usually upward sloping)iii. Liquidity Premium TheoryAssumes: Bonds of different maturities ARE substitutes, BUT NOT perfect substitutes AND investors prefer short-term bonds to long-term bondsThese 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.EX: Assume 1 year bond yields = 5% and are expected to remainthere foreverSo lnt increases with “n.” The longer the maturity the bigger theliquidity premiumLiquidity Premium Theory Formula:int=it+it+ 1e+it +2e+ …+it +n−1en+lnt“Why are 2 year bond rates higher than 1 year bond rates?”- People expect interest rates to increase and- People prefer short term bondsII. Bond Investing Strategya. 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 percentii. Liquidity premium = based on this strategy is ALWAYS .2%1. Ignores that the liquidity premium increases over timeIII. Yield Curves and Expected InflationExpected Inflation = ieAnd increase in expected inflation shifts the yield curve upThe nominal interest rate = real interest rate - iea. Yield Curve Shapes and their meaningsYTM5%MaturityExpectations TheorySegmented MarketsLiquidity Premium (lnt)MaturityYTMMaturityYTMie is expected to fall (Inverted Yield Curve)MaturityYTMie is expected to rise MaturityYTMie is expected to fall a bit MaturityYTMie is expected to rise a bit- Inverted Yield Curves predict recessions within about a yearo 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


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TAMU ECON 311 - Term Structure of Interest Rates and Yield Curves

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