The Slope and Shape of the Yield Curve - Assignment Example

The Slope and Shape of the Yield Curve. Student’s Name Institution The Slope and Shape of the Yield Curve. Introduction. The yield curve shape gives an idea of the future economic activities, and most importantly as related to this work, the idea of the future interest rate trend. Yield curves show three major shapes that make them classified as inverted, normal and flat yield curves. In the normal curves, there is the longer maturity of bonds but the yields are higher compared to the shorter-term bonds because of the time associated risks. In the inverted curves, the bonds record higher shorter-term yields as compared to the longer-term ones, and this aspect signifies an upcoming recession. Finally, the flat yield curve is indicative of an economic transition because of the small gap between short-term yields and long-term rates. On the other hand, the slope of the yield curve explains the rates of the yield. Curves with greater slopes are indicative of a large gap that is existing between the long-term and the short-term rates. Question a. Theories that explain the slope and shape of the yield curve. Studies of the yield curves have created around six theories to help the economists explain the shapes of the yield curves. One of the theories is the opportunity cost theory. The second theory is the uncertainty theory, and the third one is the liquidity theory, the fourth on is the expectations theory. The fifth one is the preferred habitat, and the sixth one is the segmented markets theories. These theories can explain the yield statistics recorded in Australia for the period between 2000 and 2010. The preferred habitat theory. This theory is an extension derives from the expectations theory and it suggests that the future long-term yields are the approximations of expected short-term yield of the future. The expectations theory derives from the idea that all investors have the willingness to buy bonds of all maturities because of their focus on the short-term yield. In theory, this idea describes a flat term structure until there is an expectation of a rise in the rates. In an expansion of this theory, the preferred habitat theory describes the investor’s focus to be both return and maturity. This theory suggests that the longer-term yields are always lower than the shorter-term yields as driven by the need to entice the investors by the means of the added premium. The added premium idea aims at encouraging the purchase of the bonds, both beyond their maturity preference and on longer terms (Neftci, 2004). The proponents of the preferred habitat theory think that for the most part, the prevalence of the short-term investors is high in the fixed-income market making the short-term rates lower than the longer-term rates. The proponents of the theory also think believe that there can occasionally be higher shorter-term rates than the longer-term rates. In this light, the bond issuers will issue more short-term bonds whenever the shorter-term rates are low regardless of their preference for the longer maturity in order for them to take advantage of the prevailing lower rates. In the context of the Australian bonds market, the investors tended to increasingly buy more bonds between 2000 and 2001 to gain profits from the shorter-term expectations of regardless of the maturity of the bonds resulting in a short-term normal yield curve. The expectations theory. The expectations theory describes the yield curve in terms of the short-term rates expectations. The theory has an assumption that a two-year bond yields the same amount as one year bond plus the return if it is ploughed back one year from today (DeFusco & Association for Investment Management and Research, 2001). It also assumes that the investors lack preference of maturity difference as well as their associated risks. In reference to this theory, any rise in the term structure of rates is indicative of the market’s expectation of the increase in the short-term rates. As a result, a rise in the rates should be observed if the two-year bonds have higher rates than the one-year bonds. The theory explains the flat curves as the result of low short-term rates or a constant future rate. Besides, an inverted curve, as explained by the theory, is an indication of the market’s belief in a sustained decline in the rates. This theory can be used to explain the situation that faced 90-day bills in Australia for the period between 2007 and 2009. During this period, the investors withdrew their willingness to buy the short-term instruments on the basis the then foreseen interest rates reduction. In fact, the rates dropped from 8% in 2009 to 3% in 2009, and a correspondent reduction in the number of bills bought was observed just as describe by the expectations theory. The uncertainty theory. The uncertainty theory derives its basis from the calendar time and it is a demand-side approach. According to the theory, the future, unlike the past that is known, is unknown and uncertain. It further describes that further movement into the future brings more uncertainty. The aspect of longer future translates into more risk. The theory describes the future as a time that has numerous uncertain events and that a longer maturity attracts many of these uncertain events that increase risks to the lender. Some of the uncertain events likely to face the lender include increase in the interest rates, defaults by the borrower, calling off the bond, changes in the tax laws as well as prices rises, amongst others (Blackwell, Griffiths & Winters, 2007). The theory explains the normal curves of the long-term bonds as because of the higher rates as a way of compensating for the more uncertainties associated with the long-term future. The theory is limited by its inadequacy in explaining the inverted yield curves. This theory, therefore, cannot explain the inverted yield curve for the period between 2000 and 2010 in Australia. The segmented markets theory. The segmented markets theory describes the shape and slope of the yield curve in terms of demand and supply in a specific maturity sector. It argues that supply and demand in a specific sector influence the interest rates that prevail in that sector. This theory can help describe all types of the yield curves in the market. Under this theory, there are three basic types of curves likely to be encountered in the market, namely inverted, humped and positive slopes. In the humped curves, the middle of the curve yields is higher than the long and the short ends of the curve. The future slope and the shape of the curve depend on the investors’ comfort and not the future market yields’ expectations. The overall yield curve shape of the Australian market for the period between 2000 and 2010 was inverted, and it is explained by the lowering demand for the Treasury bonds in the same market and for the same period. The same situation explains the negative slope of the curve observed for the period between 2000 and 2010. The liquidity theory. The liquidity theory highlights the requirement for the investors of their compensation for the interest rate risks related to the long-term issues. The theory observes that the longer maturity of the longer-term securities translates into their greater price volatility. The shape of the yield curve, according to this theory, is dependent on the rates’ expectations as well as the interest-rate risk’s premium (Bodie, Kane & Marcus, 2011). According to the theory, the interest-rate risk and, consequently, the yield premium increase with maturity. This theory cannot describe the future trend of an upward sloping yield curve. However, whether the curve becomes flat, declines or continues to be upward sloping the yield premium will expand and restore a positive slope regardless of the short-term interest rates. This theory explains the flat and the declining curves by suggesting that the rates will only decline in the short-run, but it can be corrected by the increase in the yield premium as the maturity increases. Between the year 2000 and 2010, the entire yield curve of the Australian market was inverted. This theory suggests that yield premium increases with maturity and hence the long-run future is likely to have a positive curve because of the corrective aspect of the yield premium. The opportunity cost theory. This theory works on the assumption that investors prefer dollars today over dollars tomorrow. As a consequence, this theory links longer bonds maturity to greater opportunity costs. As such, longer-term bonds should have higher rates as a way to compensate the holders for the associated opportunity cost of the longer maturity. The theory explains the normal curves of the longer-term bonds as the result of the influence of the higher rates provided to the holders as incentives to help them invest in the long-term financial instruments and compensate for the time-related risks (Casabona & Traficanti, 2002). This theory does not have an explanation for the inverted curves like the one that was recorded on the Australian market in the period between the year 2000 and 2010. Question b. Explain how interest rates and term to maturity affect the marketability of defined kinds of financial instruments. Interest rates and terms of maturity of the financial instruments determine how marketable they are to the investors. Generally, all investors seek to make riskless investment making them pay close considerations to the interest rates and terms of maturities of their securities of interest (Duignan, 2013). This aspect is created by the interest of the investors to benefit from their money through capital gains, interests, indemnification or premiums associated with the invested cash. Terms of maturity and interest rates affect such financial instruments as bonds, stocks, hedge funds, mutual funds, options, futures and currency swaps, amongst others (Fabozzi, 2002). Effects of the interest rates on the marketability of the financial instruments. Interest rates affect the prices of the financial instruments. The yields offered on financial instruments is dependent on the evaluated associated risk, as assessed through a similarly marketed riskless transaction, that is, a historically related financial instrument that attracted zero risk (Vance, 2003). When the rates of interest fluctuate, a respective change is made on the yield of the financial security. As a general rule, a rise in the interest rate causes a fall in the price of the financial instrument in question. However, a fall in the interest rate causes a respective rise in the price of the bond (Lyroudi, 2006). All these events affect the demand for the financial instrument because the price is the most important of the determinants. From the perspective of the demand, it can be deduced that a rise in the interest rate causes an increase in demand and a correspondent improved the marketability of the financial instrument, for example, the Treasury bonds. Contrariwise, a fall in the interest rate results in reduced demand and a correspondent reduction of the marketability of the specific financial instrument, for example, a bond. Effects of the terms of maturity on the marketability of the financial instruments. As a general observation of most theories used in the financial market, the longer the term to maturity the higher the risk of loss of the principal because of the uncertainties of the future. This view has led to the emergence of the term marketable securities that describes the liquid securities with a high likelihood of fetching quick profits within short durations. Marketable securities generally have terms of maturity hat are limited to one year. Terms of maturity affect the liquidity of the financial instrument in two ways. Financial instruments with less than on year term to maturities are highly marketable and have a high characteristic liquidity. The investors prefer such financial instruments because the rate at which they can be sold or bought exhibit little impacts on the prices. The second influence of the terms of maturity on the marketability of the financial pertains to the lower demand of the financial instruments with longer terms to maturity. Investors link longer terms to maturity to a myriad of uncertainties and risks that can result in loss (Wild, 2012). This aspect reduces the demand for the securities to the investors, causing the low characteristic liquidity of such securities and financial instruments with long terms to maturity. References. Blackwell, D. W., Griffiths, M. D., & Winters, D. B. (2007). Modern financial markets: Prices, yields, and risk analysis. Hoboken, N.J: Wiley. Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investments. New York: McGraw-Hill/Irwin. Casabona, P., & Traficanti, R. M. (2002). Investment pricing methods: A guide for accounting and financial professionals. New York: Wiley. DeFusco, R. A., & Association for Investment Management and Research. (2001). Quantitative methods for investment analysis. Charlottesville, Va: Association for Investment Management and Research Duignan, B. (2013). Banking and finance. New York: Britannica Educational Pub. Fabozzi, F. J. (2002). The handbook of financial instruments. Hoboken, N.J: Wiley. Lyroudi, K. (2006). Issues in investment analysis. Bradford, England: Emerald Group Pub. Neftci, S. N. (2004). Principles of financial engineering. San Diego, Calif: Elsevier Academic Press. Reference pdf documents. Vance, D. E. (2003). Financial analysis & decision making: Tools and techniques to solve financial problems and make effective business decisions. New York: McGraw-Hill. Wild, R. (2012). Bond investing for dummies. Hoboken: John wiley. Read More