FINC 490-04 Seminar in Finance Fall 2002 Lecture #2 Investments September 24

Theories of the Term Structure

There are three widely discussed theories to explain the shape, or slope, of the Term Structure of Interest Rates. (1) Market Expectations Theory (2) Liquidity Preference Theory (3) Market Segmentation Theory

Market Expectations Theory

The Market Expectations Theory holds that all arbitrage opportunities in credit markets are constantly being traded away. This means all different methods to borrow and lend over a given period must be equal (assuming identical risk across the securities). This implies that all expectations of all future interest rates are impounded in the current Term Structure; these are called Forward Rates. An important fundamental assumption of this theory is that all bonds are perfect substitutes.

Liquidity Preference Theory

This theory holds that the bonds are not perfect substitutes. Some bonds are more liquid than other. These more liquid bonds command a higher price than less liquid bonds. Higher prices imply lower returns. The clear presumption is that shorter-term bonds are more liquid than longer-term bonds, which explain the persistent, upward-sloping nature of the Term Structure.

Market Segmentation Hypothesis

This theory holds that there is little attempt to arbitrage across the different sections of the Term Structure. In short, there are some traders who are involved only in short-term bond markets, and other who are involved only in long-term markets. This would explain why we see different rates prevailing in bond markets of different maturity; why there are different rates on short-term and long-term bonds.

Estimating Forward Rates

Once we start talking about bonds of different maturities having different yield, we need a more sophisticated nomenclature to describe rates. We will use the following notation
X

rY

where X is the year the loan is made, and Y is the year the loan is paid. For instance, if we talk about a yield 3 r 7 , this is the yield on a loan made three years from today, and to be repaid seven years from today. In short, a four-year loan made three years from today. Imagine we look at the Term Structure today and observe the following rates prevailing
0 0 0

r1 r2 r5

0.04 0.05 0.06

Note that the current yield curve is all yields with X = 0. We know the yields on a oneyear, two-year, and five-year pure discount bond. This is a typical upward-sloping Yield Curve. According to the Market Expectations Theory, the markets perception of the expected yield on a one-year loan, made one year from today, 1 r 2 , is impounded in the current Term Structure.

Since all arbitrages are eliminated whether I borrow (or lend) in the form of a two-year loan, or a series of two one-year loans, the following must be equal (1+ 0 r 2 ) 2 = (1+ 0 r 1 )(1 + 1 r 2 ) Since we know 0 r 1 and 0 r 2 , we can substitute, and solve for 0 r 2
(1 .05 ) 2 = (1 . 04 )( 1 + 1 r 2 ) (1 + 1 r 2 ) = (1 . 05 ) 2 (1 .04 )

(1 + 1 r 2 ) = 1 .0601

The presumption is that if you can lend today at 4% for one year, and at 5% for two years, the expectation of the rate on a one-year loan next year (Forward Rate) must be 6%. If not one of the two paths would be less expensive, creating an arbitrage opportunity.

Similarly, we could solve for the expected rate on a three-year loan made two years from today, an 2 r 5 . This is a bit more algebraically complicated, but the basic idea holds. (1+ 0 r 5 ) 5 = (1+ 0 r 2 ) 2 (1+ 2 r 5 ) 3 (1 .06 ) 5 = (1 .05 ) 2 (1+ 2 r 5 ) 3
(1 + 2 r 5 ) 3 = (1 . 06 ) 5 (1 . 05 ) 2
1 3

(1 . 06 ) 5 (1 + 2 r 5 ) = 2 (1 . 05 ) (1 + 2 r 5 ) = 1 . 06672

According to the Market Expectations Theory, the expected return (Forward Rate) on the three-year in two years must be 6.672%. Recall that our original Term Structure was upward-sloping. Notice that if this is the case, the forward rates we compute are, by definition, always higher than the current rates that go into computing them. This implies that the market is constantly expecting next years interest rates will be higher than this years rates. This seems highly unlikely. Therefore, it seems that the Market Expectations Theory doesnt really work very well, and we should interpret the forward with extreme skepticism.