Understanding Interest Rates: Segmented Markets Theory vs. Liquidity Premium Theory, Slides of Financial Market

Download Understanding Interest Rates: Segmented Markets Theory vs. Liquidity Premium Theory and more Slides Financial Market in PDF only on Docsity! 2009/6/22 1 TERM STRUCTURE OF INTEREST RATES(2) SEGMENTED MARKETS THEORY, LIQUIDITY PREMIUM THEORY 3 B1. No Substitutability For investors, bonds with different maturities are COMPLETELY DIFFERENT, and never substitutable. Assumptions of the Segmented Markets Theory B.2 Preference for Shorter Maturity Investors usually prefer short-term bonds to long-term bonds. 2009/6/22 2 4 this year next year 1-year bond 2-year bond 1-year bond Investors regard the two strategies as completely different, and never try to substitute one for another under any situation. Moreover, investors usually prefer to take the latter strategy, composed of short-term bonds. 5 The yields on different-maturity bonds are SEPARATELY DETERMINED in their segmented markets. No substitutability among different maturities No effects of one market on another Relatively larger demands for short-term bonds For shorter-term bonds, higher prices For SHORTER MATURITIES, LOWER YIELDS Term structure implied by the segmented markets theory Preference for short-term bonds+ 2009/6/22 5 10 03.0202.002.0 ×<+ ( ) 03.0202.002.0 <+ Due to relatively high liquidity, short-term yield can be lower than long-term yield Investors require long-term bonds to have extra yields relative to short-term bonds. Liquidity Premium LIQUIDITY PREMIUM ( ) 03.001.0202.002.0 =++ LIQUIDITY PREMIUM 11 To be more general … L e it i +,1 interest rate on a one-year bond year ahead that we expect “today”i L tn i , today’s interest rate on an -year bond n ( ) tntn e nt e t e tt il n iiii ,, 1,12,11,1,1 =+ ++++ −+++ L -year bond rate must equal the average of one-year bond rates plus the liquidity premium for -year bond. n n n L tn l , liquidity premium for -year bond n 2009/6/22 6 12 Implications for Yield Curves Long-term yields are higher than the average of short-term yields by the liquidity premium. Liquidity premium is larger for longer maturity. 2% 3% 4% 5% 6% 2-year rate 2.5% 2.5+0.1= 2.6% 3-year rate 3.0% 3.0+0.2= 3.2% 4-year rate 3.5% 3.5+0.3= 3.8% 5-year rate 4.0% 4.0+0.4= 4.4% Expectations theory predicts … LP theory predicts … Expectations of future one-year rates 13 1.5 2 2.5 3 3.5 4 4.5 5 5.5 1 2 3 4 5 Expectations theory yield curve LP theory yield curve Liquidity premium The LP theory predicts that the slope tends to be POSITIVELY BIASED. 2009/6/22 7 14 1.5 2 2.5 3 1 2 3 4 5 1.5 2 2.5 1 2 3 4 5 When the expectations theory predicts a flat yield curve, LP theory predicts an upward- sloping one. Even when the expectations theory predicts a downward- sloping yield curve, LP theory can still predict an upward- sloping one. 15 Liquidity Premium Theory and the FACTS Explains the Fact 1 & 2; the theory’s prediction is basically equal to the expectations theory’s, except for the positive bias for the slopes of yield curves. Also explains the Fact 3; the theory predicts an upward-sloping yield curve, except when short-term yields are expected to decline very sharply in the future. The LP theory explains consistently all of the empirical facts about the pattern of yield curves!