FNCE 30001 Investments

Semester 2, 2011
12 & 14 October 2011
Week 10: The Term Structure of Interest
Rates Rates
Professor Rob Brown
FNCE 30001 Investments 10.0
Lecture 9: The Term Structure of Interest
Rates
Overview of Lecture
1. Zero Rates, Forward Rates and Actual Rates ,
2. What Determines the Forward Rate?
3. The Term Structure of Interest Rates (TSIR): Definition 3. T e Te St ct e o te est ates (TS ): e t o
4. TSIR Explanations (1): The Expectations Hypothesis
5. TSIR Explanations (2): The Liquidity Premium Hypothesis 5. TSIR Explanations (2): The Liquidity Premium Hypothesis
6. Interpreting the Slope of the TSIR
Reading: Bodie et al Chapter 15 Reading: Bodie et al, Chapter 15.
FNCE 30001 Investments 10.1
1. Zero Rates, Forward Rates
d A l R and Actual Rates
FNCE 30001 Investments 10.2
Zero Rates Forward Rates and Actual Rates Zero Rates, Forward Rates and Actual Rates
Zero rate: the interest rate for the period from today (time 0)
to a future date. Symbol: z.
3
0 1 2
3
z
01
z
02
z
03
The arrows go in both directions because the interest rate
applies to both borrowing and lending.
FNCE 30001 Investments 10.3
Zero Rates Forward Rates and Actual Rates Zero Rates, Forward Rates and Actual Rates
F d h i d ( i 0) f h Forward rate: the interest rate, set today (time 0), for the
period from one future date to another future date. Symbol: f.
0 1 2 3
f
12
f
23
f
13
The arrows go in both directions because the interest rate
applies to both borrowing and lending.
FNCE 30001 Investments 10.4
Zero Rates Forward Rates and Actual Rates Zero Rates, Forward Rates and Actual Rates
Example: f
13
is the interest rate set today (time 0) and
applying from time 1 until time 3.
Th i if i h l k i h i That is, if someone wishes to lock in the interest rate on a
loan to begin at time 1 and end at time 3, they can go to
the forward market and get a forward contract and the the forward market and get a forward contract and the
interest rate will be set at f
13
.
FNCE 30001 Investments 10.5
Zero Rates Forward Rates and Actual Rates Zero Rates, Forward Rates and Actual Rates
Actual (future) rate: the market interest rate at a future time. ( )
Symbol: r.
For example, r
13
means the interest rate applying from time 1 to
time 3.
We wont know the value of r
13
until we get to time 1.
By definition, r
01
= z
01
; r
02
= z
02
; r
03
= z
03
etc
0 1 2 3 0 1 2 3
The arrows go in both directions because the interest rate
applies to both borrowing and lending
r
12
r
23
r
01
FNCE 30001 Investments 10.6
applies to both borrowing and lending.
Zero Rates Forward Rates and Actual Rates Zero Rates, Forward Rates and Actual Rates
Discount factors
As we know, there is a discount factor associated with each
zero rate.
For example, d
04
is defined as:
1
A d th r i for rd di t f t r i t d ith h
( )
=
+
04
4
04
1
.
1
d
z
And there is a forward discount factor associated with each
forward rate.
For example d is defined as: For example, d
14
is defined as:
( )
=
+
14
3
14
1
.
1
d
f
FNCE 30001 Investments 10.7
( )
+
14
1 f
2. What Determines the Forward
R ? Rate?
FNCE 30001 Investments 10.8
What Determines the Forward Rate? What Determines the Forward Rate?
The forward rate can be determined from the current zero rates.
Example: Forward rate f
35
Suppose I have $X that I want to invest for 5 years. Then:
1. The obvious thing to do is to lend $X for a term of 5 years (ie buy
5 ) a 5-year zero).
But there are lots of other things I could do. For example, I could:
d b 2. (a) Lend $X for a term of 3 years (ie buy a 3-year zero) AND
(b) Buy a forward contract to buy a 2-year zero at time 3.
FNCE 30001 Investments 10.9
What Determines the Forward Rate? What Determines the Forward Rate?
Example: Forward rate f
35
(contd.)
0 2 3
4
1
5
f
(1) z
05
(2)
f
35
(2) z
03
Effectively, (1) and (2) are the same thing.
Therefore, the return on (1) and (2) should be the same.
If the returns are not the same there is an arbitrage (a free lunch).
FNCE 30001 Investments 10.10
What Determines the Forward Rate? What Determines the Forward Rate?
Example: Forward rate f
35
(contd.)
1. Lending $X for a term of 5 years (ie buying a 5-year zero).
At the end of the 5th year I will have $X (1+z
05
)
5
.
2. (a) Lending $X for a term of 3 years (ie buying a 3-year
zero).
At the end of the 3rd year I will have $X (1+z
03
)
3
.
(b) Buying a forward contract to buy a 2-year zero at time 3.
At the end of the 5
th
year I will have $X (1+z
03
)
3
(1+f
35
)
2
.
FNCE 30001 Investments 10.11
What Determines the Forward Rate? What Determines the Forward Rate?
Example: Forward rate f
35
(contd.)
To prevent arbitrage we require that:
( ) ( ) ( )
+ = + +
5 3 2
05 03 35
$ 1 $ 1 1
which implies that:
X z X z f
( )
( )
(
+
= (
(
1 2
5
05
35
3
p
1
1
z
f
( ) (

<
3
03
1+z
The general formula (for ) when the current date is time 0: t T
( )
( )

(
+
= (
+
(

1 ( )
0
0
1
1
T t
T
T
tT
t
t
z
f
z
1.
FNCE 30001 Investments 10.12
( ) (

0t
z
What Determines the Forward Rate? What Determines the Forward Rate?
Numerical Example
The zero rate for t = 5 years (z
05
) is 7.25% pa.
The zero rate for T = 8 ears (z ) is 8 755% pa The zero rate for T = 8 years (z
08
) is 8.755% pa.
What is the forward rate (pa) for the period from t = 5 to T = 8? (ie what is f
58
?)
Answer 1
( )
( )

(
+
= (
+
(

0
0
1
1
1
T
T t
T
tT
t
t
z
f
z
( )
( )

(
=
(
(

1
8
8 5
58
5
1.0875
1
1 0725
f
( )
( )
(

=
=
1/3
1.0725
1.37862967 1
11 297% pa
FNCE 30001 Investments 10.13
11.297% pa
What Determines the Forward Rate? What Determines the Forward Rate?
We can rearrange:
1
( )
( )

(
+
= (
+
(

1
0
0
1
1
1
T
T t
T
tT
t
t
z
f
z
to find that:

( ) ( ) ( )

+ + + 1 1 1
T t T t
f
What is the
( ) ( ) ( )
+ = + +
0 0
1 1 1 .
T t tT
z z f
=
1 1 1
Hence:
intuition here?
( ) ( ) ( )

=
+ + +
=
0 0
0 0
Hence:
1 1 1
T t T t
T t tT
T t tT
z z f
ie d d d
=
0
0
T
tT
t
d
d
d
FNCE 30001 Investments 10.14
3. The Term Structure of Interest
R D fi i i Rates: Definition
FNCE 30001 Investments 10.15
The Term Structure of Interest Rates:
Definition
Th f i (TSIR) f h diff The term structure of interest rates (TSIR) refers to the different
interest rates that, at a given time, apply to different investment
terms.
Various curves describe the relationship(s) between interest rate
and term. The three most often used interest rate curves are:
z : zero rate curves;
f : forward rate curves (for one-period investments); and
y : yield curves.
These represent investors views about the interest rates on:
- b d - current zero-coupon bonds;
- future zero-coupon bonds; and
- current coupon bonds
FNCE 30001 Investments 10.16
- current coupon bonds.
The Term Structure of Interest Rates:
Definition
Flat curve: f = z = y ;
Rising curve: f > z > y ; and
Falling curve: f < z < y .
We will use term structure of interest rates to mean todays
f f h i i set of zero rates for the various terms to maturity.
We established these
r l ti n hip in W k 8 relationships in Week 8
FNCE 30001 Investments 10.17
4. TSIR Explanations (1):
Th E i H h i The Expectations Hypothesis
FNCE 30001 Investments 10.18
TSIR Explanations (1):
The Expectations Hypothesis
Usually, long-term interest rates are higher than short-term
interest rates why?
B i l i l h h But sometimes, long-term interest rates are lower than short-
term interest rates why?
It is critical to know the term structure to price bonds It is critical to know the term structure to price bonds.
Two major explanations:
Th E p t ti H p th i The Expectations Hypothesis
The Liquidity Premium Hypothesis.
FNCE 30001 Investments 10.19
TSIR Explanations (1):
The Expectations Hypothesis
Assume that investors are risk neutral.
By definition, risk neutral investors ignore risk. They care
l b d only about expected returns.
Faced with a choice between two investments, a risk neutral
investor will always choose the one with the higher expected investor will always choose the one with the higher expected
return
even if it is much riskier and the expected return is only a even if it is much riskier and the expected return is only a
little higher.
FNCE 30001 Investments 10.20
TSIR Explanations (1):
The Expectations Hypothesis
C id h f ll i h i $X f 3 Consider the following three ways to invest $X for 3 years:
1. Buy a 3-year zero today;
2 I iti ll shorter th th i tm t h riz 2. Initially, go shorter than the investment horizon:
a. Buy a 2-year zero today and
b At the end of the 2 years collect the par value and b. At the end of the 2 years, collect the par value, and
then buy a 1-year zero.
3. Initially, go longer than the investment horizon: y, g g
a. Buy a 4-year zero today and
b. Sell it at the end of 3 years.
The return from Strategy 1 is certain why?
But the returns from Strategies 2 and 3 are risky why?
FNCE 30001 Investments 10.21
TSIR Explanations (1):
The Expectations Hypothesis
S 1 Strategy 1
The sum that will be accumulated by Strategy 1 is:
S = $X (1+ )
3
S
1
= $X (1+ z
03
)
3
.
Strategy 2
The sum that will be accumulated by Strategy 2 is: The sum that will be accumulated by Strategy 2 is:
S
2
= $X (1 + z
02
)
2
(1 + r
23
).
Today (time 0), r
23
is unknown, but investors today expect it Today (time 0), r
23
is unknown, but investors today expect it
to be E(r
23
).
So, the sum expected to be accumulated by Strategy 2 is:
E(S
2
) = $X (1 + z
02
)
2
[1+E(r
23
)]
FNCE 30001 Investments 10.22
TSIR Explanations (1):
The Expectations Hypothesis
C i S i 1 d 2 Comparing Strategies 1 and 2:
If S
1
> E(S
2
) then risk-neutral investors will choose Strategy 1.
If E(S ) > S th ri k tr l i t r ill h Str t 2 If E(S
2
) > S
1
then risk-neutral investors will choose Strategy 2.
Therefore, in equilibrium, S
1
= E(S
2
).
That is $ X (1+ z )
3
= $X (1 + z )
2
[1+E(r )] That is, $ X (1+ z
03
) = $X (1 + z
02
) [1+E(r
23
)].
Hence (1+ z
03
)
3
= (1 + z
02
)
2
[1+E(r
23
)].
Generalising from this example, for two future dates t and T Generalising from this example, for two future dates t and T
(where t < T ):
(1+ z
0T
)
T
= (1 + z
0t
)
t
[1+E(r
t T
)]
T t
.
FNCE 30001 Investments 10.23
TSIR Explanations (1):
The Expectations Hypothesis
Strategy 3
The sum that will be accumulated by Strategy 3 is:
( )
+
=
+
4
04
3
34
$ 1
.
1
X z
S
r
Today (time 0), r
34
is unknown, but investors today expect it
to be E(r
34
).
b d b So, the sum expected to be accumulated by Strategy 3 is:
( )
( )
+
=
4
04
$ 1
E
X z
S
( )
( )
=
+
3
34
E
1 E
S
r
FNCE 30001 Investments 10.24
TSIR Explanations (1):
The Expectations Hypothesis
Comparing Strategies 1 and 3:
If S
1
> E(S
3
) then risk-neutral investors will choose Strategy 1.
1
(
3
) gy
If E(S
3
) > S
1
then risk-neutral investors will choose Strategy 3.
Therefore, in equilibrium, S
1
= E(S
3
). , q ,
1
(
3
)
That is,
( )
+
4
$ 1 X z
( )
( )
( )
( )
+
+ =
+
3
04
03
34
4
$ 1
$ 1
1 E
1
X z
X z
r
( )
( )
( )
+
+ =
+
4
3
04
03
34
1
Hence 1
1 E
z
z
r
FNCE 30001 Investments 10.25
TSIR Explanations (1):
The Expectations Hypothesis
Comparing Strategies 1 and 3 (contd.):
Generalising from this example, for two future dates t and T
( h t < T ) (where t < T ):
( )
( )
( )

+
+ =
(
0
0
1
1
T
t
T
t
T t
z
z
Rearranging this equation, we find:
( )
+ (

1 E
T t
tT
r
( ) ( ) ( )

+ = + + (

0 0
1 1 1 E
hi h i h l f d h
T t
T t
T t tT
z z r
which is the same result we found when we
compared Strategies 1 and 2.
FNCE 30001 Investments 10.26
TSIR Explanations (1): TSIR Explanations (1):
The Expectations Hypothesis
Interpretation:
If the expected returns are the same, risk-neutral investors do
h h h f h i i not care whether the term of their investment:
Matches their investment horizon (Strategy 1)
I h h h i i h i (S 2) Is shorter than their investment horizon (Strategy 2)
Is longer than their investment horizon (Strategy 3).
This is because, by definition, they do not care about risk.
If the expected returns are the same, they place no value on
the fact that Strategy 1 is less risky than Strategies 2 and 3.
FNCE 30001 Investments 10.27
TSIR Explanations (1):
The Expectations Hypothesis
Compare this equation: p q
(1+ z
0T
)
T
= (1 + z
0t
)
t
[1+E(r
t T
)]
T t
with this one we covered earlier:
Assumes risk neutrality
(1 + z
0T
)
T
= (1 + z
0t
)
t
(1 + f
t T
)
T t
Assumes there are no
arbitrage opportunities
Thus, according to the expectations hypothesis:
E(r
t T
) = f
t T
This is the heart of the Expectations Hypothesis:
Th k d f h h The market sets todays term structure of zero rates such that
the resulting forward rates are equal to the markets expectations of
future interest rates.
FNCE 30001 Investments 10.28
f
TSIR Explanations (1):
The Expectations Hypothesis
Thousands of things g
Expected future interest rates
Todays zero rates
(ie todays term structure)
Todays forward rates
Trade bonds
Do forwards = expected?
Trade bonds
Equilibrium TSIR
YES NO
FNCE 30001 Investments 10.29
Equilibrium TSIR
TSIR Explanations (1):
The Expectations Hypothesis
ll h d h h h Recall that according to the expectations hypothesis:
( ) ( )
( )
0 0
1 1 1 E
T t
T t
T t t T
z z r

(
+ = + +

Suppose t = 2 and T = 3. Then:
( )

( ) ( ) ( )
+ = + + (

3 2
1 1 1 E z z r
But the expectations hypothesis also maintains that when
1 d T 2 h
( ) ( ) ( )
+ = + + (

03 02 23
1 1 1 E z z r
t = 1 and T = 2 then:
( ) ( ) ( )
+ = + + (

2
02 01 12
1 1 1 E z z r
( ) ( ) ( ) ( )
+ = + + + ( (

3
03 01 12 23
So 1 1 1 E 1 E z z r r
FNCE 30001 Investments 10.30
TSIR Explanations (1):
The Expectations Hypothesis
l f h f h Generalising from this gives us a more convenient statement of the
expectations hypothesis.
For any given term to maturity of T, the hypothesis states that the current y g y , yp
zero rate for that term (z
0T
) is set by the market such that:
( ) ( ) ( ) ( )
( )
0 01 12 23 1
1 1 1 E 1 E ... 1 E
T
T T T
z z r r r
(
+ = + + + + ( (


( ) ( ) ( ) ( )
( )
( ) ( ) ( )
( )
{ }
0 01 12 23 1,
1
0 01 12 23 1
...
Therefore:
1 1 E 1 E ... 1 E 1
T T T
T
T T T
z z
z z r r r

( (


(
= + + + + ( (


This is a geometric average of the zero and the expected rates.
( ) ( ) ( )
( )
{ } 0 01 12 23 1,
1 1 E 1 E ... 1 E 1
T T T
z z r r r

+ + + + ( (


If the expectations hypothesis is true, then the expected rates are equal to the
forward rates.
FNCE 30001 Investments 10.31
TSIR Explanations (1):
The Expectations Hypothesis
Th t i th p t ti h p th i b t t d thi That is, the expectations hypothesis can be stated this way:
The current zero rate for a term of T years is a function of
the current zero rate for Year 1 and the expected one year the current zero rate for Year 1 and the expected one-year
rates for Year 2, Year 3, Year 4, etc up to T years.
FNCE 30001 Investments 10.32
TSIR Explanations (1):
The Expectations Hypothesis
Example 1
Suppose the expectations hypothesis is true.
Todays one-year zero rate (z
01
) is 10.0%.
The expected one-year rates are:
Year 1: E(r
12
) = 12.0%
Year 2: E(r
23
) = 13.0%
Year 3: E(r
34
) = 13.4%
Year 4: E(r
45
) = 13.5%
What is todays term structure of interest rates?
FNCE 30001 Investments 10.33
TSIR Explanations (1):
The Expectations Hypothesis
Answer to Example 1
According to the expectations hypothesis, the market will set todays zero
rates such that todays forward rates equal expected future rates rates such that today s forward rates equal expected future rates.
Therefore f
12
= E(r
12
) = 12.0%.
( )
+
2
02
1
B d fi iti 1
z
f
( )
( )
=
+
+
02
12
01
2
02
By definition 1
1
1
Th f 0 12 1
z
f
z
z
( )
=
= =
02
02
Therefore 0.12 1
1.10
which solves to give 0.10995 10.995%
z
z
By similar reasoning we can find z
03
, z
04
and z
05
.
FNCE 30001 Investments 10.34
TSIR Explanations (1):
The Expectations Hypothesis
Or, just applying the formula:
( ) ( ) ( )
( )
{ }
(
= + + + + ( (


1
0 01 12 23 1,
1 1 E 1 E ... 1 E 1
T
T T T
z z r r r
( ) ( ) ( )
( )
{ }


0 0 3 ,
1 2
we get
T T T
z z
( )
( )
= =
= =
1 2
02
1 3
03
1.10 1.12 1 10.995% pa
1.10 1.12 1.13 1 11.660%pa
z
z
( )
( )

= =
03
1 4
04
1.10 1.12 1.13 1 11.660% pa
1.10 1.12 1.13 1.134 1 12.092% pa
z
z
( )
= =
1 5
05
1.10 1.12 1.13 1.134 1.135 1 12.372 z % pa
FNCE 30001 Investments 10.35
TSIR Explanations (1):
The Expectations Hypothesis
Example 2
Given these expectations, an investor wonders what next
ill l k lik years term structure will look like.
Assuming that the expectations hypothesis is true, and
expectations are fulfilled (that is at the start of next year the expectations are fulfilled (that is, at the start of next year, the
one-year rate is indeed 12% pa, as expected), what should be
the term structure next year? y
FNCE 30001 Investments 10.36
TSIR Explanations (1):
The Expectations Hypothesis
Answer to Example 2
We can summarise the results so far in the following table:
Term
Now
(ie at t = 0)
Start of next year
(ie at t = 1)
At t = 2 At t = 3 At t = 4
g
1 year z
01
=10.000% z
12
= 12.000% 13.000% 13.400% 13.500%
2 years z
02
=10.995% E(z
13
)
3 years z
03
=11.660% E(z
14
)
4 years z
04
=12.092% E(z
15
)
5 12 372% 5 years z
05
=12.372%
We want to calculate E(z
13
), E(z
14
) and E(z
15
).
FNCE 30001 Investments 10.37
TSIR Explanations (1):
The Expectations Hypothesis
Answer to Example 2 (contd.)
= = Time has in effect moved on 1 year from 0 to 1 t t
( )
{ }
= =
(
( (
1
Time has, in effect, moved on 1 year from 0 to 1.
So the relevant formula now is:
T
t t
( ) ( ) ( ) ( )
( )
{ }
(
= + + + + ( (


1 12 23 34 1,
E 1 1 E 1 E ... 1 E 1
T T T
z z r r r
Hence:
( ) ( )
= =
1/2
13
1/3
Hence:
E 1.12 1.13 1 12.4989%pa z
( ) ( )
( ) ( )
= =
= =
1/3
14
1/4
15
E 1.12 1.13 1.134 1 12.7985% pa
E 1.12 1.13 1.134 1.135 1 12.9734% pa
z
z
FNCE 30001 Investments 10.38
( ) ( )
5
TSIR Explanations (1):
The Expectations Hypothesis
Answer to Example 2
Adding these results to the table: g
Term
Now
(ie at t = 0)
Start of next year
(ie at t = 1)
At t = 2 At t = 3 At t = 4
(ie at t = 0) (ie at t = 1)
1 year z
01
=10.000% z
12
= 12.000% 13.000% 13.400% 13.500%
2 years z
02
=10.995% E(z
13
) = 12.4989% 2 years z
02
10.995% E(z
13
) 12.4989%
3 years z
03
=11.660% E(z
14
) = 12.7985%
4 years z
04
=12.092% E(z
15
) = 12.9734% y z
04
(z
15
)
5 years z
05
=12.372%
FNCE 30001 Investments 10.39
TSIR Explanations (1):
The Expectations Hypothesis
This means the TSIR is forecast to rise and flatten next year:
14.000
10.000
12.000
6.000
8.000
R
A
T
E

(
%

p
a
)
TSIR this year
TSIR next year
2 000
4.000
0.000
2.000
0 1 2 3 4 5 6
TERM (YEARS)
FNCE 30001 Investments 10.40
TERM (YEARS)
TSIR Explanations (1):
The Expectations Hypothesis
So, i f we have a forecast of next years (ti me 1's) term structure y ( )
we can deduce next year's forward curve.
The formul a when the current date i s t i me 1 i s:
( )
( )

(
+
= (
+
(

1 ( )
1
1
1
1
1
1, whi ch i mp
1
T t
T
T
tT
t
t
z
f
z
l i es:
( ) (

1t
z
( )
( )
= = =
2
23 23
1.124989
1 13.000% E
1.12000
f r
( )
( )
( )
= = =
3
34 34
2
1.12000
1.127985
1 13.400% E
1.12498
f r
( )
( )
( )
( )
= = =
4
45 45
3
1.129734
1 13.500% E
1 127985
f r
FNCE 30001 Investments 10.41
( ) 1.127985
4. TSIR Explanations (2):
Th Li idi P i H h i The Liquidity Premium Hypothesis
FNCE 30001 Investments 10.42
TSIR Explanations (2):
The Liquidity Premium Hypothesis
The Main Weakness of the Expectations Hypothesis The Main Weakness of the Expectations Hypothesis
The expectations hypothesis assumes that investors are risk neutral.
Ri k li i h d d i i Fi Risk neutrality is not the standard assumption in Finance.
If all investors were risk neutral, then (for example):
i h l h di ifi d f li f h in the long term, the return on a diversified portfolio of shares
would be the same as the interest rate on bank deposits;
no homeo ner o ld ins re their home g inst fire no homeowner would insure their home against fire.
This is a pretty strange world!
FNCE 30001 Investments 10.43
TSIR Explanations (2):
The Liquidity Premium Hypothesis
The standard assumption in finance is risk aversion.
That is, investors regard risk as undesirable.
Thus, bearing risk must be compensated by a higher
expected return.
If ll i i k h (f l ) If all investors were risk averse, then (for example):
in the long run, the return on a diversified portfolio of
h r ill d th i t r t r t b k d p it shares will exceed the interest rate on bank deposits;
at least some homeowners will insure against fire.
Thi i h lik h ld li i ! This is much more like the world we live in!
The liquidity premium hypothesis assumes that investors
are risk averse
FNCE 30001 Investments 10.44
are risk averse.
TSIR Explanations (2):
The Liquidity Premium Hypothesis
Consider again the following three ways to invest $X for 3
years:
1 B 3 d 1. Buy a 3-year zero today;
2. Initially, go shorter than the investment horizon:
B 2 d d a. Buy a 2-year zero today and
b. At the end of the 2 years, collect the par value, and then
b 1 r z r buy a 1-year zero.
3. Initially, go longer than the investment horizon:
B 4 d d a. Buy a 4-year zero today and
b. Sell it at the end of 3 years.
FNCE 30001 Investments 10.45
TSIR Explanations (2):
The Liquidity Premium Hypothesis
With risk-neutral investors (ie the expectations hypothesis),
the market will set interest rates such that the returns from
Strategies 1 2 and 3 are equal: Strategies 1, 2 and 3 are equal:
( ) ( ) ( )
( )
( )
+
+ = + + = (

+
4
3 2
04
03 02 23
34
1
1 1 1 E
1 E
z
z z r
r
Suppose instead that investors are risk averse.
S pp l th t e er i t r i thi m rk t h 3 r
( )
+
34
1 E r
Suppose also that every investor in this market has a 3-year
investment horizon.
FNCE 30001 Investments 10.46
TSIR Explanations (2):
The Liquidity Premium Hypothesis
Th Then:
( ) ( ) ( )
( )
(
+
( (
1 2
3
3 2
03
1
1 1 1 1 d
z
( ) ( ) ( )
( )
( )
( )
( )
( ) ( )
{ }
+ < + + > ( (

+
(

+
(
3 2
03
03 02 23 02
23
4
1 4
3 3
04
1 1 1 E 1 and
1 E
1
1 1 1 E 1
z
z z r z
r
z
Thus, because of risk aversion, both the 2-year rate (z
02
) and
( )
( )
( )
( ) ( )
{ }
+ < > + + (

+
3 3
04
03 04 03 34
34
1 1 1 E 1
1 E
z
z z z r
r
Thus, because of risk aversion, both the 2 year rate (z
02
) and
the 4-year rate (z
04
) will be higher than in a risk-neutral world.
Investors have to be offered higher interest rates to induce
them to go shorter (2 years) and longer (4 years) than their
horizon.
FNCE 30001 Investments 10.47
TSIR Explanations (2):
B i i lik l h ll i (l d ) ld h
The Liquidity Premium Hypothesis
But it is most unlikely that all investors (lenders) would have
the same investment horizon (3 years).
Some investors (lenders) would have a 2-year horizon some a Some investors (lenders) would have a 2-year horizon, some a
3-year horizon, some a 4-year horizon etc.
However, according to the liquidity premium hypothesis, g q y p yp
there is a pattern.
This pattern is: There is a systematic tendency for borrowers to want to
b f l n r p i d th l d t t l d borrow for longer periods than lenders want to lend.
That is, investors (lenders) display a preference for liquidity
(making shorter-term loans). (making shorter term loans).
Hence, investors (lenders) require extra inducement if they are
to make long-term loans.
FNCE 30001 Investments 10.48
TSIR Explanations (2):
The Liquidity Premium Hypothesis
According to the liquidity premium hypothesis, the relevant
case to look at is where an investor is induced to lend for a
term that exceeds the investment horizon: term that exceeds the investment horizon:
As in the case where investors have a 3-year horizon but
are induced to buy a 4-year zero: are induced to buy a 4 year zero:
( )
( )
( )
+
+ <
4
3
04
03
1
1
z
z
( )
( )
( )
( )
+
+
+
03
34
4
3
04
1 E
1
Th f 1
z
r
z
( )
( )
( )
+ =
+ +
04
03
34 34
34
Therefore: 1
1 E
where is an extra return (a liquidity premium).
z
z
r L
L
FNCE 30001 Investments 10.49
34
where is an extra return (a liquidity premium). L
TSIR Explanations (2):
The Liquidity Premium Hypothesis
( )
( )
( )
+
=
+
4
04
34 34
3
03
1
Therefore: 1 E
1
z
L r
z
( )
( )
=
34 34
E f r
( )
= +
34 34 34
which we can rewrite as: E f r L
The liquidity premium hypothesis says that the zero rates
(term structure) set by market participants produce forward
( )
34 34 34
f
rates that are equal to the relevant expected rate plus a little bit
this little bit being the liquidity premium
Th li idi i b d i i h The liquidity premium may be assumed to increase with term.
FNCE 30001 Investments 10.50
TSIR Explanations (2):
The Liquidity Premium Hypothesis
Thousands of things g
Expected future interest rates
Todays zero rates
(ie todays term structure)
Todays forward rates
Trade bonds
Do forwards = expected + L ?
Trade bonds
Equilibrium TSIR
YES NO
FNCE 30001 Investments 10.51
Equilibrium TSIR
TSIR Explanations (2):
The Liquidity Premium Hypothesis
The general effect of having a liquidity premium is that there is a
bias towards longer-term interest rates being higher than would
be justified purely on the basis of expectations of future interest be justified purely on the basis of expectations of future interest
rates.
Note that the liquidity premium hypothesis builds on the Note that the liquidity premium hypothesis builds on the
foundation of the expectations hypothesis;
both hypotheses maintain that expectations are important. yp p p
To avoid confusion, they are sometimes renamed:
expectations hypothesis pure expectations hypothesis expectations hypothesis pure expectations hypothesis
liquidity premium hypothesis biased expectations hypothesis
FNCE 30001 Investments 10.52
TSIR Explanations (2):
The Liquidity Premium Hypothesis
Suppose a time came when lenders had a longer-term
investment horizon than borrowers.
Wh i h hi h ? When might this happen?
Then lenders would need to be induced to lend for short
periods periods.
The liquidity premium would be negative.
Th t i th r ld b p lt ppli d t l d r h That is, there would be a penalty applied to lenders who
wanted to lend for long periods.
FNCE 30001 Investments 10.53
5. Interpreting the Slope of the
TSIR TSIR
FNCE 30001 Investments 10.54
Interpreting the Slope of the TSIR Interpreting the Slope of the TSIR
d b l Suppose, today, we observe a particular term structure.
Given belief in a theory of the term structure we may be able to infer what
investors expectations are. p
For example,
if todays term structure is flat (at 10% pa),
then
- if we believe in the pure expectations hypothesis,
investors must expect interest rates will not change in the future; investors must expect interest rates will not change in the future;
but
- if we believe in the liquidity premium hypothesis, and also believe
that the liquidity premium rises with term, then investors must
expect interest rates to fall in the future.
FNCE 30001 Investments 10.55
Interpreting the Slope of the TSIR Interpreting the Slope of the TSIR
Todays TSIR
P i
Interest
Pure expectations:
All forward rates = 10% pa
All expected rates = 10% pa
rate (pa)
10%
LL
t,t+1
Rising liquidity premium:
All forward rates = 10% pa
All expected rates = 10% L
t, t+1
Term (years ahead)
FNCE 30001 Investments 10.56
INTERPRETING THE TSIR WITH A RISING LIQUIDITY PREMIUM
Interpreting the Slope of the TSIR Interpreting the Slope of the TSIR
Excluding the possibility of a negative liquidity premium, the
slope of the term structure is interpreted as shown in the table:
If todays term
structure of
Then market expectations of future interest rates are:
According to the (pure) According to the liquidity
interest rates is:
g (p )
expectations hypothesis
g q y
premium hypothesis
Increasing Increasing Increasing, Flat or Decreasing
Flat Flat Decreasing
Decreasing Decreasing Decreasing
FNCE 30001 Investments 10.57