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The Yield Curve zYield Curve (Term Structure of Interest Rates): A plot of the interest rates of Treasury Bills and Treasury Bonds versus their maturities at a point in time.

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Yield Curve: An Example Term (years) Interest Rate (%)

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The Slope of the Yield Curve zUpward Sloping (Term i ) -- usual case. zDownward Sloping (or Inverted) Yield Curve (Term i ) -- occurs periodically zWhat information can we get from the yield curve?

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Observed Phenomena -- Yield Curve zThe downward sloping (inverted) yield curve is unusual but not rare. zInterest rates of bonds of all maturities move together (are positively correlated) zThe downward sloping (inverted) yield curve tends to occur when interest rates in general are high.

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Theories (Hypotheses) Which Explain Yield Curve Behavior zKey difference in assumptions: How close of substitutes are bonds of different maturities? zWe will assess each hypothesis – how well does it predict the three observed phenomena?

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(1) Expectations Hypothesis zThe Expectations Hypothesis -- The interest rate on a long-term bond will be equal to the average of short-term rates expected to occur over the lifetime of the long-term bond. zKey assumption: Bonds of different maturities are perfect substitutes.

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Assessment: Expectations Hypothesis zThe downward sloping (inverted) yield curve is unusual but not rare. Fails to predict this occurrence. (predicts probability of upward versus downward slope)

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Expectations Hypothesis zInterest rates of bonds of all maturities move together (are positively correlated) Accurately predicts this occurrence. (bonds are substitutes)

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Expectations Hypothesis zThe downward sloping (inverted) yield curve tends to occur when interest rates in general are high. Accurately predicts this occurrence (When are interest rates expected to decrease?)

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(2) The Market Segmentation Hypothesis zThe Market Segmentation Hypothesis -- Each investor has his/her preferred maturity sector and stays within it. Consequently, interest rates on bonds are determined by independent demand and supply conditions within that sector.

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Market Segmentation Hypothesis: Assumption zKey Assumption: Bonds of different maturities are not substitutes at all.

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Market Segmentation Hypothesis: Predictions zUpward sloping yield curve is the usual case -- more demand for short-term bonds than long-term bonds. zDownward sloping yield curve -- contractionary Federal Reserve policy, increases short-term rates without affecting long-term rates.

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Assessment: Market Segmentation Hypothesis zThe downward sloping (inverted) yield curve is unusual but not rare. Accurately predicts this occurrence. (Highly contractionary monetary policy)

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Market Segmentation Hypothesis zInterest rates of bonds of all maturities move together (are positively correlated) Fails to predict this occurrence. (Independently determined interest rates should not move together)

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Market Segmentation Hypothesis zThe downward sloping (inverted) yield curve tends to occur when interest rates in general are high. Accurately predicts occurrence. (High expected inflation, contractionary monetary policy)

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(3) The Preferred Habitat Hypothesis zThe Preferred Habitat Hypothesis The interest rate on a long-term bond equals the average of short- term rates expected to occur over the lifetime of the long-term bond plus a risk premium due to higher market risk in the long-term bond.

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Preferred Habitat Hypothesis: Assumption zKey assumption -- Bonds of different maturities are close substitutes but not perfect substitutes. zMajor non-price difference -- longer term bonds have higher market risk.

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Assessment: Preferred Habitat Hypothesis zThe downward sloping (inverted) yield curve is unusual but not rare. Accurately predicts occurrence. (Investors must expect interest rates to decrease a lot in the future.)

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Preferred Habitat Hypothesis zInterest rates of bonds of all maturities move together (are positively correlated) Accurately predicts this occurrence. (Close substitutes)

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Preferred Habitat Hypothesis zThe downward sloping (inverted) yield curve tends to occur when interest rates in general are high. Accurately predicts occurrence (When are interest rates expected to decrease a lot?)

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Intepretations of a Yield Curve zDifferent theories attach different interpretations based on assumptions

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Return to the Yield Curve Example Term (years) Interest Rate (%)

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Interpretations of Yield Curve from Example zExpectations Hypothesis – investors expect interest rates to increase. zMarket Segmentation Hypothesis – normal bond market conditions. zPreferred Habitat Hypothesis – investors expect interest rates in the future to either increase, say level, or decrease by a small amount.

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The Yield Curve: Additional Topics zThe U-Shaped (or J-Shaped) Yield Curve: different interpretations depending upon underlying hypothesis. zIs the inverted Yield Curve a good predictor for recessions in the overall economy?

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