Fixed Interest Securities and Derivatives - Literature review Example

Download file to see previous pages The expectations theory states that a longer-term bond rate is only the mean of anticipated one-period rates for the period of the bond with the addition of some fixed term premium. Based on this theory, the spreads amongst diverse maturities constitute the cointegrating vectors. If there was found only one general trend, it was resolved that the term premia then must be mean-returning if not constant.
Shea (1992) studied a more extensive set of yields, which included the long-term maturities up to 25 years. The results of his study supported the verdicts of Hall et al. (1992) for the short end of the yield curve but eliminated fixed spreads which comprised the longer-term maturities. Working upon Shea (1992), other investigators discovered three common trends when they included yields of longer maturities. Zhang (1993) established this for US data while Carstensen (2003) for German data.
There are a variety of hypotheses that can describe any slope which the yield curve may take. The simplest theory is the pure expectations theory. The use of the expectations theory in the study of the yield curve can be deciphered as far back as that Fisher (1896). The Expectations Theory presumes that all financial tools on the yield curve are absolutely substitutable. In this, the forward rates solely correspond to the predictable future rates. As these rates either rise or fall for any time period, the shape of the yield curve can be either upward sloped or downward for that particular period.
Peterson (2001) had actually attempted to make clear the inaccuracy of the Expectations Theory. He states that “there is a rational bias for investors to go ‘with the crowd.’ Specifically, he shows that an institutional investor going against the crowd has a high degree of visibility to one’s superiors. The risk/reward calculation is biased toward not ‘sticking one’s neck out.’ If he goes against the crowd and rightly predicts the market, he gains some positive recognition. However, if he goes against the crowd and wrongly predicts the market’s movements, then it could be the end of his career.” Consequently, the estimates are logically colored to go along with the crowd. These activities skew the yield curve and develop results that contravene the Expectations Theory. ...Download file to see next pagesRead More