The Slope and Shape of the Yield Curve - Assignment Example

Name Institution affiliation Slope and shape of the yield curve Slope and shape of the yield curve a) A yield curve denotes the association amid the time to maturity and the cost of borrowing for a particular debtor in a particular exchange. The yield curve involves a curve that shows various yields or the interest rates across several contract lengths that can be years or even 20 years for a comparable debt contract. There are various shapes of the yield curve where we have the steep yield curves, inverted yield curves, normal yield curves as well as flat yield curves (Term Structure of Interest Rates, 2016). There are various theories that describe the association between the interest charges and period to maturity and the marketability of different definite varieties of financial instruments. Interest rates that are offered on various financial instruments depend on various factors that comprise of level of risk, duration, market trends and regulatory framework. Based on the period of maturity of the financial instruments the interest rates are classified as short-term interest rates like the short maturity, medium-term and the long-term interest rates like the corporate bonds, securities of government or the long-term bonds. An investor or the portfolio planner anticipates a particular rate of interest to have a compensation for the three elements that include compensation for risk like risk premium, compensation for waiting like for time and compensation or loss of the purchasing power (Srivastava, 2015). The theories that show the relationship between interest rates and term to maturity and the marketability of different defined kinds of financial instruments include the following Liquidity preference theory shows the connection between the charge of borrowing and term of maturity. It adds a premium to the PET that involves the calculate yield for the long duration debts to represent the stockholder preferences for the short period bonds as compared to the long-term debts. The premium recognizes the risks that are associated with holding the long-term debts that is more probable to experience the catastrophic events as well as prices uncertainty as compared to the short-term debt. The 2nd premium is comprised in LPT for the defaulting risk that is supplementary probable during holding a bond for the long-term of the time and this is due to the level of uncertainty ("Yield Curve – Theories", 2017). The expectations theory shows that the long rates are essential tools that assist in forecasting the future short rates. This theory shows the relationship between the short-term maturity durations and the costs of borrowing and therefore it states that the investors have different choices when it comes to the investment in the bonds of various maturities and this is because it assumes that the risk is similar. The upward slope of the yield curve denotes that the short period rates will stay to increase, the flat curve means that the rates will either increase or stay flat while the downward sloping of the yield curve indicates that the rates will continue to decrease (Sundarkumar, 2017). Pure expectations theory assumes that at any maturity of the obligation can be substituted for each other over the process of compounding. In case there is an expectation that one-year interest rate will be one year from present day then one can be able to govern the current the two-year interest rate as the compounded summation of the one-year forward and the current one-year rate. The association between the borrowing cost and the term to maturity can be associated with the geometric average of the shorter durations yields as the determining factor of the longer duration yields. The concept recognizes the fact that the returns tend to vary together over time of maturity, on the other side the does not describe the specifics of the form of the yield curve. The theory advocates that the forward rates are the critical predicting elements of the future rates but it does not take into account the interest rate risk as well as the reinvestment risk. It suggests that the capability to the arbitrage among various maturity bonds tends to lower ("Yield Curve – Theories", 2017). Market segmentation theory shows the connection between the interest rates and duration to maturity and the marketability of different definite types of financial instruments where it suggests that the financial instruments of various periods are not compatible. The demand and supply in the marketplaces for the long duration and the short duration instruments tends to be determined mostly independently. The potential investors choose in advance either the short duration or the long period financial instruments. The investors may opt their investment portfolio to be liquid and this means that they will tend to prefer the short period instruments over the long period instruments. Thus, the market for the short period instruments will tend to have a greater demand as compared to the long-term financial instruments. The higher demand for the instruments means that there is greater prices and lesser returns on the same and this shows the conventional fact that the short duration yields are typically lesser than the long duration yields. Therefore, this theory tends to describes the prevalence of the normal yield curve figure ("The Yield Curve", 2017). market segmentation theory states that the individual investors as well as the FIs have particular maturity preferences and convincing them of their most preferred that needs a higher interest rate (Cornett, Adair, & Nofsinger, 2016). Preferred habitat theory involves the extension of the market segmentation theory that suggests that maturity preference or the habitats for the debt investors like prefer 6-year maturities or 3-year bonds. If one wants to trade bonds outside to the investor the investors’ favorite investment limit, one should offer the investors a premium. It is because the theory assumes that most of the potential traders have the short duration habitats. It also explicates the greater returns on the long duration debts, consistency with the propensity of the long and short duration debt yield curve segmentations so as to hold the shape when the entire yields variation. If the yields discrepancies in the bonds outside their overall maturity sections tend to have much benefits on them then the investors will tend to put their money into these bonds. Even if most of the investors frequently deal with the 10-year bonds, if they anticipate that the 5-year bonds are economical then they will accumulate into it. b) The reserve bank sustained the cash rate target of 1.5 percent from the month of August 2016. The short duration interest rates in the repurchase contract market go on being high as compared to the OIS rates. Over the past few years, the repo rates at which the bank tends to undertake its open market operations have risen from being close to the OIS rates to approximately 30 basis points above the OIS rates. The Australian dollars may be rent against yen at a relatively high rate and this implies that the Australian dollar interest rate due to some of the investors have borrowed the Australian dollar on the basis of repo so as to use them for the foreign exchange swap businesses. The yields on the 10-year Australian government securities that followed the movements in the United States treasury yields and have decreased by 40 basis points from early month of March. The spread the is between 10-year the Australian government securities as well as the treasury yields has been approximately 30 basis points that is close to its lowest level from the year 2001. Figure 1: Australian government bond yields Source: www.rba.gov.au The figure 1 above shows the relationship between the functional connection between the term to maturity and the yield to maturity of the Australian bonds. It shows how the yield on the interest bearing the security is being affected by the variation in the duration of maturity. The relation is being observed through keeping all the relevant as well as yield sensitive factors that include market trends, marketability, liquidity, default risk, tax structure and credit rating constant except for the maturity period. The relationship is well understood through taking the same government bonds and having the differences in maturity only. The association between the term to maturity and interest rate assists in the representation of the yield curve that tends to represent the returns that are realized across various maturity dates. The yield curve is downward sloping when the interest rate for the longer maturity duration is less as compared to the shorter maturity duration. The reason for this downward sloping yield curve is due to the decreased anticipation with the decrease in the maturity as long maturity investments have more liquidity as compared to the short-term maturity investments. Also, the downward slope can be as a result of the long maturity that induces an element of the less risk and therefore the investors tend to demand low yield so as to compensate for the less risk. The demand for the Australian government securities is strong and the present bond bids have typically been well acknowledged. Also, the Australian office of the financial management issued $11 billion of the new 10-year bond in the month of February that involved the largest Australian government securities syndication to the present day. The level of the accrued semi-government bonds remains the same at approximately $240 billion in the year 2017 and this comprise the issuance by the Western Australian as well as the Queensland that is offset by maturities from the New South Wales ("Statement on Monetary Policy – May 2017 | RBA", 2017). A large volume of bonds has been issued by the non0residents in the local market from the start of the year 2017. The issuance was mainly from the supranational agencies, the offshore banks and typically for the longer maturities as compared to the previous years and this shows a continuous trend from the year 2016. Through the conversion of the Australian dollars they tend to raise into the foreign currency through the use of the foreign exchange swap market, the bond issuers directly assisted the Australian corporations that looked to hedge the funding that was raised offshore back into the Australian dollars. References Cornett, M. M., Adair, T. A., & Nofsinger J. (2016). M: Finance(3rd Ed.). New York, NY: McGraw-Hill Term Structure of Interest Rates. (2016). Retrieved February 21, 2016, fromhttp://www.investinganswers.com/financial-dictionary/bonds/term-structure-interest-rates-2936 Srivastava, R. (2015). Derivatives and risk management. New Delhi: Oxford Univ. Press. Yield Curve – Theories. (2017). Hedge Fund Writer. Retrieved 5 September 2017, from http://www.hedgefundwriter.com/2011/05/11/yield-curve-%E2%80%93-theories/ Sundarkumar, A. (2017). Yield Curve Slope, Theory, Charts, Analysis (Complete Guide) |WSM. Free Investment Banking Tutorials | WallStreetMojo. Retrieved 5 September 2017, from http://www.wallstreetmojo.com/yield-curve-slope-theory-charts-analysis/ The Yield Curve. (2017). Boundless. Retrieved 5 September 2017, from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/bond-valuation-6/additional-detail-on-interest-rates-62/the-yield-curve-283-3881/ Reserve Bank of Australia. (2017). Reserve Bank of Australia. Retrieved 5 September 2017, from http://www.rba.gov.au Statement on Monetary Policy – May 2017 | RBA. (2017). Reserve Bank of Australia. Retrieved 5 September 2017, from https://www.rba.gov.au/publications/smp/2017/may/ Read More