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METAFILEPICTb^ +  .1  ``&  & MathType` CG TimesC- 2 xfk 2 ik CG Times- 2 7eb CG Times- 2 1p 2 ~2p 2 1p 2 2p 2 9,I 2 m,ISymbol- 2 = & "Systemn-)-,&OLE 2.0 Box <=8C HKKKK !  ݛC  ##C    )((  Finance4000MoneyandCapitalMarketsFifthclass  8S((dd8  $      F23  0    Whatdeterminesinterestratedifferentials?Fq݌j(#(# Ќ      '23  0    Examples'R݌>(#(# Ќ        0  23  0` (#(#  Federalgovernmentbondshaveloweryieldsthanthose   issuedbyprivateagents ݌ ` (#` (# Ќ        0  23  0` (#(#  Privateagentsbondshavedifferentyields 2݌P ` (#` (# Ќ   d   d0  0` (#(#2-3  0 ` (#` (#  lowerbondrating"e.g.baaversusaaa" $  implieshigheryieldtomaturityd)݌  (# (# Ќ   d   d40  0` (#(#2-3  0 ` (#` (#  FHA30yearsbondsinbetweenaaaandbaa b  bondsd4_݌  (# (# Ќ        I0  23  0` (#(#  Stateandlocalbondshavealoweryieldthanfederal P governmentbonds It݌ ` (#` (# Ќ        d0  23  0` (#(#  Thesedifferentialsvaryovertime d݌` (#` (# Ќ    H     d 23  0    Defaultriskd ݌j(#(# Ќ        % 0  23  0` (#(#  Atleastpartlyexplains % P ݌>` (#` (# Ќ   d   d 0  0` (#(#2-3  0 ` (#` (#  ݀yieldsonprivatebondsrelativetofederalbondsd 1 ݌  (# (# Ќ   d   d 0  0` (#(#2-3  0 ` (#` (#  baayieldrelativetoaaayieldd = ݌  (# (# Ќ         0  23  0` (#(#  defaultrisk"thechancethatpaymentswillnotbe j  madeaspromisedinthebond  6 ݌ ` (#` (# Ќ        30  23  0` (#(#  Riskpremium 3^݌ ` (#` (# Ќ   d   d0  0` (#(#2-3  0 ` (#` (#  Compensationforbearingriskd3݌| (# (# Ќ   d   d0  0` (#(#2-3  0 ` (#` (#  Definedastheinterestrateonthebondminusthe P riskfreerated*݌  (# (# Ќ   d   d&0  0` (#(#2-3  0 ` (#` (#  Usuallymeasuredastheinterestrateonthebond  minustheinterestrateonfederalbondsd&Q݌  (# (# Ќ   j   jf0  0` (#(#0 ` (#` (#23  0 (# (#  Federalbondshavenonominaldefaultrisk # "riskfreenominalratejf݌ (#(# Ќ      0  0` (#(#0 ` (#` (#0 (# (#2*3  0h(#(#  doesnotmeanthattheyhaveariskfree &! realyieldtomaturity݌ h(#h(# Ќ      0  0` (#(#0 ` (#` (#0 (# (#2*3  0h(#(#  DoTIPShaveariskfreerealyieldto t)$ maturity?݌*.&h(#h(# Ќ      ;23  0    Howdoesdefaultriskbecomereflectedintheprice?;f݌(#(# Ќ        $0  23  0` (#(#  Assumebondsaresubstitutes $O݌X ` (#` (# Ќ         0  23  0` (#(#  Howdoesthepriceofbondscometoreflectthe , | perceiveddefaultriskinequilibrium?  4݌ ` (#` (# Ќ   d   d40  0` (#(#2-3  0 ` (#` (#  Demandandsupplyd4_݌j  (# (# Ќ   d   d0  0` (#(#2-3  0 ` (#` (#  Whatifsomeonehasadifferentopinionthanis >  reflectedinthemarketpriceofthebonds?dJ݌  (# (# Ќ      `23  0    Taxes`݌|(#(# Ќ        0  23  0` (#(#  Howdoesthetaxfreestatusofinterestonstateand P localbondsbecomereflectedintheprice? E݌ ` (#` (# Ќ   d   dO0  0` (#(#2-3  0 ` (#` (#  DemandandsupplydOz݌ (# (# Ќ   j   j:0  0` (#(#0 ` (#` (#23  0 (# (#  Assumebondsaresubstitutesj:e݌b"(#(# Ќ   j   jG0  0` (#(#0 ` (#` (#23  0 (# (#  IgnoredefaultriskonstateandlocalbondsjGr݌6% (#(# Ќ   d   dd 0  0` (#(#2-3  0 ` (#` (#  Whosetaxrateisreflectedinthedifferencein  (Z# yieldsonstateandlocalbondsrelativetoTreasurysecurities?dd ݌*.& (# (# Ќ      !23  0    Liquiditypremiums?!!݌j(#(# Ќ        "0  23  0` (#(#  Liquiditypremiumistheextrarateofreturnfor > holdingalessliquidbond ""݌ ` (#` (# Ќ        #0  23  0` (#(#  WidelytradedTreasurysecuritiesprobablyarethe , | mostliquidsecurities ##݌ ` (#` (# Ќ        $0  23  0` (#(#  Effectsofchangesinliquidity $$݌j ` (#` (# Ќ        %0  23  0` (#(#  1987 %%݌> ` (#` (# Ќ        &0  23  0` (#(#  Recent? &&݌b ` (#` (# Ќ   d   dO'0  0` (#(#2-3  0 ` (#` (#  LongTermCapitalManagementunwinding 6 positionsdO'z'݌  (# (# Ќ         z(23  0    Thetermstructureofinterestratesz((݌j(#(# Ќ      S)23  0    YieldcurvesfornominalTreasurybondsandTIPSS)~)݌>(#(# Ќ        8*0  23  0` (#(#  Ayieldcurveshowshowtheyieldtomaturityofa   bondvariesasthetermtomaturityvaries 8*c*݌ ` (#` (# Ќ   d   dj+0  0` (#(#2-3  0 ` (#` (#  bondsthatareidenticalotherthantermtomaturitydj++݌P  (# (# Ќ      x,23  0    Generalobservationsaboutbondyieldsx,,݌$ (#(# Ќ        S-0  23  0` (#(#  Yieldsonbondswithdifferentmaturitiestendtogoup   anddowntogether.Thereisalargecommonfactorinbondyields. S-~-݌ ` (#` (# Ќ         .0  23  0` (#(#  Whenshortterminterestratesarelow,theyieldcurve P ismorelikelytoslopeup.Whenshortterminterestratesarehigh,theyieldcurveismorelikelytoslopedown. ..݌ ` (#` (# Ќ         "00  23  0` (#(#  Onaverage,shortertermbondshavealoweryieldthan b" longertermbonds. "0M0݌ ` (#` (# Ќ   6%       U123  0    ExplanationsofthetermstructureU11݌j(#(# Ќ        ,20  23  0` (#(#  Expectationshypothesis ,2W2݌>` (#` (# Ќ   d    d 30  0` (#(#2-3  0 ` (#` (#  Theyieldcurvereflectsexpectationsoffuture   shortterminterestratesd 373݌  (# (# Ќ         ;40  23  0` (#(#  Segmentedmarketstheory ;4f4݌P ` (#` (# Ќ   d    d50  0` (#(#2-3  0 ` (#` (#  Relativebondyieldsdependonlyonrelative $  demandandsupplyd5G5݌  (# (# Ќ         @60  23  0` (#(#  Preferredhabitattheory @6k6݌b ` (#` (# Ќ   d    d!70  0` (#(#2-3  0 ` (#` (#  Differentholdersandissuersofbondsprefer 6 differentmaturitiesbutdifferentmaturitiesaresubstitutesd!7L7݌  (# (# Ќ   d    dr80  0` (#(#2-3  0 ` (#` (#  Liquiditypreferencetheorydr88݌ (# (# Ќ   j    jg90  0` (#(#0 ` (#` (#23  0 (# (#  Everythingelsethesame,holdersofbonds b" prefershortertermbondsthanissuerswanttoissuejg99݌ (#(# Ќ   d    ed:0  0` s#s#2-3  0 ` s#` s#  Theexpectationshypothesisisfundamentalforthe  (Z# preferredhabitatandliquiditypreferencetheoriesd::݌  s# s# Ќ   *.&         s<23  0    ATperiodbondyieldalwayscanbebrokendownintoT X  singleperiodinterestratess<<݌ s#s# Ќ        =0  23  0` s#s#  Thisisindependentofanytheoryofthetermstructure ==݌ ` s#` s# Ќ       >23  0    Example"twoperiodbond>>݌j s#s# Ќ        X?0  23  0` s#s#  Issuerisborrowingfortwoperiods X??݌> ` s#` s# Ќ         D@0  23  0` s#s#  Discountbond D@o@݌b ` s#` s# Ќ         A0  23  0` s#s#  Twoperiodbondyieldisi2whenissued AEA݌6` s#` s# Ќ   d    dB0  0` s#s#2-3  0 ` s#` s#  Bondyieldis10percentperyeardB;B݌  s# s# Ќ   d    d C0  0` s#s#2-3  0 ` s#` s#  Initialamountborrowedandlentis$100d C6C݌ s# s# Ќ   d    d D0  0` s#s#2-3  0 ` s#` s#  Pays(1.10)2$100=$121twoyearslaterd D8D݌b" s# s# Ќ   d    dE0  0` s#s#2-3  0 ` s#` s#  CandecomposethisintotwooneyearloansdE=E݌6%  s# s# Ќ   &!        :F0  23  0` s#s#  Borrow$100forfirstyear :FeF݌, |` s#` s# Ќ   d    dG0  0` s#s#2-3  0 ` s#` s#  Whatinterestrate?dGHG݌P  s# s# Ќ   j    j H0  0` s#s#0 ` s#` s#23  0 s# s#  Interestrateatwhichoneyearloanscurrently $  beingmadej H5H݌ s#s# Ќ       AI0  0` s#s#0 ` s#` s#0 s# s#2*3  0hs#s#  Supposethatinterestrateis10percent b  alsoAIlI݌ hs#hs# Ќ       |J0  0` s#s#0 ` s#` s#0 s# s#2*3  0hs#s#  Impliesthat$110wouldbepaidbackat P theendoftheyear|JJ݌ hs#hs# Ќ   $t m7$9)%`|0w `Eo Rww$ T m  j        \L0  23  0` s#s#  Supposeborrow$110forsecondyear \LL݌` s#` s# Ќ   d    dHM0  0` s#s#2-3  0 ` s#` s#  ThisisaforwardloandHMsM݌ s# s# Ќ   j    j8N0  0` s#s#0 ` s#` s#23  0 s# s#  Aloancontractedtodayforadateinthe X  futurej8NcN݌ s#s# Ќ   j    jeO0  0` s#s#0 ` s#` s#23  0 s# s#  contractforadateforwardintimejeOO݌ s#s# Ќ   d    dyP0  0` s#s#2-3  0 ` s#` s#  Whatinterestrate?dyPP݌j  s# s# Ќ   j    jfQ0  0` s#s#0 ` s#` s#23  0 s# s#  Denoteitbyh.4$ ` \y4: `-/EL>::L>:hjfQQ݌> s#s# Ќ       R0  0` s#s#0 ` s#` s#0 s# s#2*3  0hs#s#  forwardratestartinginperiod1and 1  endinginperiod2RR݌ hs#hs# Ќ       T0  0` s#s#0 ` s#` s#0 s# s#0hs#s#2+3  0hs#hs#  Knowthattwoyearloanstodayare o at10percentT=T݌ s#s# Ќ       cU0  0` s#s#0 ` s#` s#0 s# s#0hs#s#2+3  0hs#hs#  Knowthatoneyearloanstodayare C at10percentcUU݌ s#s# Ќ       ƵV0  0` s#s#0 ` s#` s#0 s# s#0hs#s#2+3  0hs#hs#  10percentwouldseemsensibleƵVV݌1#s#s# Ќ   j    jW0  0` s#s#0 ` s#` s#23  0 s# s#  h.4$ ` \M `.E&LMLL&LMhjWX݌&U!s#s# Ќ   j    jBY0  0` s#s#0 ` s#` s#23  0 s# s#  h.4$ ` \qXX `. E* X W* XhjBYmY݌ * &s#s# Ќ       *,XX$%XX*Z23  0    ExpectationshypothesisofthetermstructureZZ݌js#s# Ќ        [0  23  0` s#s#  Implicitforwardinterestratesequalexpectationsof > futureoneperiodrates [[݌ ` s#` s# Ќ   d    d\0  0` s#s#2-3  0 ` s#` s#  Leth.'4$ ` \y `%/EJ , ccJ , ch߀betheexpectedinterestforperiod1to2d\\݌, | s# s# Ќ   d    d9^0  0` s#s#2-3  0 ` s#` s#  h.+4$ ` \y `/E W Whd9^d^݌W  s# s# Ќ         {_0  23  0` s#s#  Why? {__݌ ` s#` s# Ќ   d    dH`0  0` s#s#2-3  0 ` s#` s#  Supposethepeoplerespondtoexpectedearnings V  "profitsfromalternativestrategiesdH`s`݌  s# s# Ќ   d    da0  0` s#s#2-3  0 ` s#` s#  Iftheexpectedreturnfromholdingtwosuccessive  1periodbondsisgreaterthantheexpectedreturnfromholdingone2periodbond,thenholdtwo1periodbondswithhigherreturndaa݌  s# s# Ќ   d    d"c0  0` s#s#2-3  0 ` s#` s#  Iftheexpectedreturnfromholdingone2period ! bondweregreaterthanholdingtwosuccessive1periodbonds,thenholdthe2periodbondwithhigherreturnd"cMc݌  s# s# Ќ   d    dd0  0` s#s#2-3  0 ` s#` s#  Otherwaystoprofitifcansellshortthe1period ($ or2periodbondddd݌  s# s# Ќ   +&        e0  23  0` s#s#  Basicpointofexpectationshypothesis ef݌` s#` s# Ќ   d    d[g0  0` s#s#2-3  0 ` s#` s#  Peoplecareabouttheperiodswhentheyborrowor  makeloansd[gg݌  s# s# Ќ   d    d}h0  0` s#s#2-3  0 ` s#` s#  Peopledonotcareaboutthetermtomaturityof   bondsthattheybuyandselltoborrowandlendd}hh݌  s# s# Ќ   j    ji0  0` s#s#0 ` s#` s#23  0 s# s#  Simplestcase"holdtwosuccessive1period P  bondsorone2periodbondjii݌ s#s# Ќ         k0  23  0` s#s#  Implicationsforinterpretingtermstructureofinterest P  rates k?k݌ ` s#` s# Ќ         +l0  23  0` s#s#   d    dl0  0` s#s#2-3  0 ` s#` s#  forwardratesdll݌>  s# s# Ќ   d    dm0  0` s#s#2-3  0 ` s#` s#   d    den0  0` s#s#2-3  0 ` s#` s#  bondyieldsdenn݌b  s# s# Ќ   |      _o23  0    Segmentedmarketshypothesis_oo݌js#s# Ќ        0p0  23  0` s#s#  Agentscareabouttermtomaturityofbonds 0p[p݌>` s#` s# Ќ   d   d$q0  0` s#s#2-3  0 ` s#` s#  Savingforretirement,buylongtermbondd$qOq݌  s# s# Ќ   d   d'r0  0` s#s#2-3  0 ` s#` s#  Financingaplant,issuelongtermbondd'rRr݌  s# s# Ќ   d   d(s0  0` s#s#2-3  0 ` s#` s#  Savingforahouse,buyshorttermbondd(sSs݌j  s# s# Ќ   d   d)t0  0` s#s#2-3  0 ` s#` s#  Financinginventory,issueshorttermbondd)tTt݌>  s# s# Ќ   d   d-u0  0` s#s#2-3  0 ` s#` s#  Nothingelsegoingond-uXu݌b  s# s# Ќ        v0  23  0` s#s#  Implicationsfortermstructureofinterestrates vGv݌6` s#` s# Ќ   d   dw0  0` s#s#2-3  0 ` s#` s#  Relativebondyieldsareafunctionofrelative   demandandsupplydwAw݌ $t s# s# Ќ      Ex23  0    PreferredhabitathypothesisExpx݌js#s# Ќ        y0  23  0` s#s#  Peoplehavetobepaidtochangethematurityoftheir > assetsandliabilitiesbutafinitepaymentwillinducethemtochange yAy݌ ` s#` s# Ќ        hz0  23  0` s#s#  Implicationfortermstructure hzz݌ ` s#` s# Ќ   d   dO{0  0` s#s#2-3  0 ` s#` s#  Bondyieldsareafunctionofexpectationsand j  relativedemandandsupplydO{z{݌  s# s# Ќ        ~|0  23  0` s#s#  Problem ~||݌ ` s#` s# Ќ   d   dN}0  0` s#s#2-3  0 ` s#` s#  PrettyvacuousdN}y}݌| s# s# Ќ   d   d6~0  0` s#s#2-3  0 ` s#` s#  Whyhigheryieldonlongtermbonds?d6~a~݌P s# s# Ќ   j   j40  0` s#s#0 ` s#` s#23  0 s# s#  Justhappenstobej4_݌$ts#s# Ќ   j   j70  0` s#s#0 ` s#` s#23  0 s# s#  Couldbetheoppositej7b݌ Hs#s# Ќ   #     S23  0    LiquiditypreferencehypothesisS~݌js#s# Ќ        '0  23  0` s#s#  Ingeneral,peopleprefertoholdshorttermbonds 'R݌>` s#` s# Ќ   d   d"0  0` s#s#2-3  0 ` s#` s#  Duetointerestrateriskd"M݌  s# s# Ќ   d   d0  0` s#s#2-3  0 ` s#` s#  Ignoresreinvestmentriskorsassumesavery   particularstructureofpreserferencesofissuersandlenderholdersofbondssod@݌  s# s# Ќ         0  23  0` s#s#  Implicationfortermstructure  8݌> ` s#` s# Ќ   d   d0  0` s#s#2-3  0 ` s#` s#  Onaverage,termstructureslopesupwardeven b  thoughtheaverageexpectedchangeiszerod݌  s# s# Ќ   d   d20  0` s#s#2-3  0 ` s#` s#  Whenthetermstructureslopesupward,interest P ratesmaybeexpectedtoincreased2]݌  s# s# Ќ   j   jh0  0` s#s#0 ` s#` s#23  0 s# s#  Ifincreasegreaterthanliquiditypremiumjh݌$ts#s# Ќ   j   j0  0` s#s#0 ` s#` s#23  0 s# s#  Havetoestimateliquiditypremiumj݌s#s# Ќ   d   d0  0` s#s#2-3  0 ` s#` s#  Whenthetermstructureisflat,interestratesare b" expectedtodecreased݌  s# s# Ќ   d   dÌ0  0` s#s#2-3  0 ` s#` s#  Whenthetermstructureslopesdownward,interest &! ratesareexpectedtodecreasedÌ݌  s# s# Ќ