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Chapter 7: Learning Objectives

Chapter 7: Learning Objectives. Term Structure of Interest Rates. Chapter 7: Learning Objectives. Term Structure of Interest Rates expectations & other hypotheses. Chapter 7: Learning Objectives. Term Structure of Interest Rates expectations & other hypotheses

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Chapter 7: Learning Objectives

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  1. Chapter 7:Learning Objectives • Term Structure of Interest Rates

  2. Chapter 7:Learning Objectives • Term Structure of Interest Rates • expectations & other hypotheses

  3. Chapter 7:Learning Objectives • Term Structure of Interest Rates • expectations & other hypotheses • real interest rate considerations

  4. Chapter 7:Learning Objectives • Term Structure of Interest Rates • expectations & other hypotheses • real interest rate considerations • Anomalies in the yield curve

  5. Long-term and short-term Government of Canada Bond Yields

  6. The Term Structure of Interest Rates: The Expectations Hypothesis • Why hold short-term vs. Long-term bonds? • Should their yields be linked to each other? E11 R1 R2

  7. The Key Relations in the Expectations Hypothesis The Simplest case: R2 = (R1 + E11)/2 The General case: Rn = (R1 + E11 + E21 + … + En-11)/n

  8. The Expectations Hypothesis: Two Examples

  9. Hypothetical Yield Curves Yield Rising Constant Falling Term

  10. Financial Focus 7.1 • Hypothetical YC are an estimate of the relationship between yield and term to maturity Yield Term

  11. Financial Focus 7.1 • Hypothetical YC are an estimate of the relationship between yield and term to maturity • Yield curves must be constructed for similar types of financial instruments Yield Term

  12. Financial Focus 7.1 • Hypothetical YC are an estimate of the relationship between yield and term to maturity • Yield curves must be constructed for similar types of financial instruments • One must not read too much into the shape/slope of a yield curve Yield Term

  13. Yield Curve Puzzles • The Yield curve is generally upward sloping

  14. Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive

  15. Table 7.3: Yield differential relative to 90-day treasury bills

  16. Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive • The yield curve tends to shift over time

  17. Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive • The yield curve tends to shift over time • Figure 7.3 shows that inflation tends to shift the entire yield curve

  18. Shifting Yield Curves

  19. Yield Curve Puzzles • The Yield curve is generally upward sloping • Table 7.3 shows that the term premium is generally positive • The yield curve tends to shift over time • Figure 7.3 shows that inflation tends to shift the entire yield curve • The slope of the yield curve tends to predict future economic activity

  20. Yield Curves and Monetary Policy

  21. Figure 7.4: Shifting yield curves

  22. Figure 7.5: The yield spread and recessions in Canada

  23. POINT: COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  24. POINT: The YC is easy to understand COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  25. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  26. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  27. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  28. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  29. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  30. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant Empirical evidence for EH weakest for US POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  31. POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant Empirical evidence for EH weakest for US Ignores many other factors that determine yields over time POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves

  32. Competing Explanations of the Term Structure • The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner

  33. LIQUIDITY PREMIUM

  34. Competing Explanations of the Term Structure • The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner • The Market Segmentation theory: Short-term and long-term markets are separate

  35. MARKET SEGMENTATION

  36. Competing Explanations of the Term Structure • The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner • The Market Segmentation theory: Short-term and long-term markets are separate • The Preferred-Habitat theory: there is limited substitutability between short-term and long-term bonds

  37. Figure 7.7: Interest rates and the maturity structure of government of Canada debt

  38. Summary • The term structure of interest rates explains why interest rates differ when their term to maturity differs

  39. Summary • The term structure of interest rates explains why interest rates differ when their term to maturity differs • The expectations hypothesis predicts that long term rates are averages of expected short-term rates

  40. Summary • The term structure of interest rates explains why interest rates differ when their term to maturity differs • The expectations hypothesis predicts that long term rates are averages of expected short-term rates • Despite the appeal of the expectations hypothesis there are “puzzles” in the behaviour of the yield curve

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