Seminar 5 - Topic 5 - Interest rate forecasting-1.pptVIP

* * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Expectations Theory Equation 13.1 (Viney) (0i1 + E1i1) 0i2 = ___________ 2 Where 0i2 = rate on a two year investment commencing today 0i1 = rate on a one year investment commencing today E1i1= expected rate that would prevail in one years time on a one year instrument Expectations Theory Rearranging equation 13.1 E1i1 = ( 0i2 * 2 ) - oi1 = ( 8 * 2 ) - 10 = 6% p.a. In other words, the expected interest rate in one year’s time on a one year security would be 6% An inverse yield curve results if the market expects future short term rates to be lower than current short term rates (1 + 0 r1) (1 + 1 r 2) = (1 + 0 r 2)2 0 1 2 1st year Bond = 10% 2nd year Bond = 6% 2 year Bond = 8% 2 Expectations Theory Assumptions: Large number of financial investors with homogenous expectations about future values of short term interest rates No transaction costs No impediments Bonds with different maturities are perfect substitutes Expectations Theory Explanation for the shape of yield curves Inverse yield curve Will result if the market expects future short-term rates to be lower than current short-term rates Normal yield curve Will result from expectations that future short-term rates will be higher than current short-term rates Flat yield Curve No difference in current and future expected rate Humped yield curve Investors expect short-term rates to rise in the future but to fall in subsequent periods “Humped Yield Curve” Segmented Markets Theory Rejects the expectations theory assumption that all bonds are perfect substitutes, or that investors are indifferent between holding short-term and longer-term securities contends that bonds may only be substitutes within certain time frames Investors have preference for securities that meet their needs e.g. insurance companies typically prefer longer-term securities; individuals prefer