Term Structure: Theoretical Challenges

1. Term Structure: Theoretical Challenges

2. Research Evidence • A number of studies reject the unbiased expectations hypothesis and find that the yield curve does not have significant predictive power in forecasting interest rates. • (Shiller, Campbell and Schoenholtz, 1983, Campbell 1986, and Mankiw 1986). • Other studies, however, find evidence consistent with the unbiased expectations hypothesis. • Froot 1989, Longstaff 1990, Fama and Bliss 1987, and Sargent 1982).

3. Research Evidence: Examples • Froot (1989) • The expectations hypothesis does not work for short maturities but for long maturities the yield curve moves point for point with changes in expected future rates. • Fama (1984) • Fama finds that the term structure can be used to forecast one-month interest rates one month ahead. • Fama and Bliss (1987) • Fama and Bliss find that one year forward interest rates can forecast changes in the one year interest rate two to four years in advance.

4. More Research Evidence: Liquidity Premiums • Kiely, Kolari, and Rose (1994) found that liquidity premiums vary over time, rising and falling with the business cycle. • They argue that the premiums arise from two opposing forces: • The price-risk hypothesis • The money-substitutes hypothesis

5. Price-Risk Hypothesis • The price-risk hypothesis claims that liquidity premiums are inversely related to the level of market interest rates. • When interest rates fall below the level that investors regard as normal, the public will begin to expect rising interest rates and to anticipate greater losses on long-term bonds. • As a result, they will demand larger liquidity premiums on longer term securities.

6. Price-Risk Hypothesis • The price-risk hypothesis claims that liquidity premiums are inversely related to the level of market interest rates • When interest rates rise above the level that investors regard as normal, the public will begin to expect falling interest rates and to anticipate greater gains on long-term bonds. • As a result, they will demand smaller liquidity premiums on longer term securities.

7. Money-Substitutes Hypothesis • The money-substitutes hypothesis suggests that a direct relationship exists between liquidity premiums and the level of interest rates. • Interest rates represent the opportunity cost of holding money and the higher cash balances are, the greater the lost potential income or opportunity cost. • We know that risk averse investors prefer to place their cash in short-term securities because the longest-term securities carry the greatest price risk.

8. Money-Substitutes Hypothesis • Therefore, as market rates rise, investors shift a portion of their cash balances into short-term securities to avoid suffering the higher opportunity costs of holding idle cash. • The added demand for short-term securities generates a more positively sloped yield curve as the liquidity premiums on long-term securities become larger relative to liquidity premiums on short-term securities.

9. Money-Substitutes Hypothesis • Consequently, a rising level of interest rates can lead to higher liquidity premiums and a more steeply sloped yield curve while a falling level of interest rates can lead to lower liquidity premiums and a flatter or downward sloping yield curve. • Kiely, Kolari, and Rose found that the price-risk hypothesis tends to be more significant in low interest-rate periods, but the money-substitutes hypothesis is more important when interest rates are relatively high.