Theories Proposed to Explain the Slope and Shape of the Yield Curve - Essay Example

Theories proposed to explain the shape of the yield curve Name: Institution: Date: The yield curve also known as the term structure of interest rates are curves that are comprised of two elements that are plotted together. Debt maturities which symbolize the length of time of the borrowing period are plotted against the interest rates. Due to the complexity of the yield curve we have various theories that attempt to explain it[Sie88]. One of the theories that is used to explain the yield curve is the pure expectations theory. In this theory we assume that through compounding any maturity of debt can substitute for any other. An example is if one has a one year interest rate view in relation to what the interest rate might be a year from now then he or she may be able to determine the interest rate two years ahead from now as the compounded sum of the current one year rate and the additional one year forward. This shows therefore that the geometric mean of the short term yields is the determinant of the long term yields. This theory tends to show that yields change together over a period of time however it fails to explain the deeper details of the shape of the yield curve. Its main basis is the notion that forward rates are the best predictors for future rates, which is a notion. It also has the characteristic of not taking into account the reinvestment risk and the interest rate risks which brings about another risk which is an individual may not reinvest compensations at a known rate. This notion makes an assumption that the power to authoritatively determine the bond growth is very low[Kar95]. The second theory that is used to explain the yield curve is the liquidity preference theory which is a theory that exist due to a change in the pure expectations theory. The changes are the fact that this theory includes a premium in the yield for the debts that grow for long periods of time in the pure expectations theory as a way of accounting for the preferences of investors for the short period maturing securities over the longer period maturity bonds. The paying term added may be known as liquidity paying term and it takes into account the risks that are as a result of long term debts, which have a high likelihood of experiencing a bad event coupled with price uncertainty which is worse than in the short term debt. In the liquidity preference theory we also include a premium for the default risk which is due to a bond being held for a longer period as a result of uncertainty[Kar95]. The market segmentation theory on the other hand is among the theories that explain the yield theory. It takes into account the notion which says that different growths of debt are impossible to be replaced with one another. The notion therefore tends to turn into different relationships with the shorter and longer maturing debts. The demand for the short term maturities rises t a high level since a lot of investors prefer them due to their low risk level. This therefore also affec s the short and longer term debts in that the short term securities will have a high demand than the long term debt making the prices of the former to be more leading to low yields. This is what makes it possible for the design of the curve to be explainable not change of the longer and shorter growing rates because they are separate and independent markets[Kar95]. Another theory that explains the yield curve is the preferred habitat theory which extends from the market segmentation theory. This theory is firmly rooted on the maturity preferences for the debt investors. Different investors prefer different maturities and bonds therefore to sell an investor a bond that is not in his preferred area the investor may ask for a premium. Due to the fact that short term habitats are more commonly preferred this explains the high yield on the long term debts and it becomes consistent therefore enabling the curve to maintain its design when the yields tend to flactuate[Kar95]. The financial fluctuation in Australian finance sectors undermines roles of monetary systems as very useful intermediate targets. The reserve bank of Australia used the cash rate as a tool in monetary policy conduct. Due to the deregulated economy the monetary shocks end up affecting the financial sector. The subsequent changes in the economy and the asset prices. In Australia the economic activity responds highly to movements in the long term interest. However, the monetary authorities use the short term interest rates as an instrument of monetary policy which in turn leads to term structure of the interest rate into becoming extremely important in the monetary transmission mechanism[wil07]. The Australian common wealth government give both the treasury notes per term which have growths between 2 to 3 weeks when issued and bonds that have various growths. The correlation between changes in the yields in the different are what explain the changes in the yield curve. Mean Median Standard deviation Maximum Minimum Treasury note 11.398 11.620 4.043 19.400 4.650 2 yr 10.500 11.500 2.112 15.100 4.100 5 yr 10.862 11.800 1.576 15.100 5.000 10 yr 11.030 11.950 1.307 15.100 5.350 Above we have a table that shows the Australian government security yields in 2000. It is very important to know that the comparison structure of yields to growth for Australia is not a variable in a huge way in the full period as compared to era from the beginning of the tenders of the treasury bond[Coh66]. Maturity 91 days 24 months 60 months 120 months 91 days 1.000 2 years 0.549 1.000 5 years 0.560 0.936 1.000 10 years 0.503 0.853 0.927 1.000 The table above summarizes the correlation between yield of the bond to the growth in one of periods found in 2000. This structure can be viewed as similar to another one which was collected in the U.S bond market. To get the amount of factors that are needed in an effort show the changes in the curve there is formula known as the multivariate factor technique. Growth 1st factor 2nd factor 3rd factor 91 days -0.776 -0.627 0.069 2 years -0.970 0.037 -0.217 5 years -0.965 0.025 -0.072 10 years -0.929 0.272 0.243 Percentage of variance explained by factor 83.4 12.8 2.9 The table above represents factor loadings for yield changes in 2000 in Australia. The factors can be interpreted to be an explanation of the different changes in the shape of the yield curve. Factor 1 affects the yield at all maturities by the same amount and in the exact same direction. Therefore due to this reason the factor may be described as a parallel shift factor. Factor 2 has a different effect on the short and long term yields and it can be called a slope factor due to the different effect it has on the long term and short term yields. Factor three on the other hand has a negative effect on the medium yields and it has good effect on the short term and long term yields. Due to this characteristic it is described as a curvature factor. Due to the second and third factors which explain about 18% of the yield curve changes of yield in the Bond market of Australia there have been portfolios which have been drafted to ensure that a set of liability cash flows have been made better with one of the factors being put in a model which may lack to do that for a calculated area of yield curve changes. It is very important that different factor models are required in ensuring the betterment of cash flows that have liabilities with the use of Australian Government bonds hand in hand to ensure that the process is successful. Two or three factor models will be enough and we do not require to have different factors in every important rate of yield to growth since there is a correlation between changes in these yields. A similar finding is also true in many markets where bonds are sold. However, the importance of different factors in the table above appear to be related in different markets[Jon02]. Yield curves create a visual instrument with differing maturities across time. It makes it possible to create a representation of interest rates. Therefore the yield curves are important since they enable one to study the financial market conditions and analyze potential investments or trading opportunities. Therefore yield curves are very important in explaining the effects of the long term and short term seciurities and it has helped us evaluate the financial state of Australia and how the theories apply in rel life situations[Nel87]. References Sie88: , (Siegel & Nelson, 1988), Kar95: , (Karfakis & Moschos, 1995), wil07: , (williams, 2007), Coh66: , (Cohen, Kramer, & Waugh, 1966), Jon02: , (Jones & Sudmeyer, 2002), Nel87: , (Nelson & Siegel, 1987), Read More