Ch2 - Liquidity premium PDF

Preview

Summary

Liquidity premium...

Description

Ch2 - Liquidity premium Wednesday, September 11, 2019

11:35 AM

Chapter 2 - Term Structure of Interest Rates; Liquidity Premium/Preference & Market Segmentation NOTES Term Structure of Interest Rates: The Yield Curve Liquidity Premium Theory • Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity ○ Builds off of the unbiased expectation theory

○

1RN = (1 + one year spot rate)(1+ expected forward rate for the second year) + premium for liquidity § For any future period, it will have a liquidity premium added to it □ The liquidity premium will rise over time ○ The formula will be very similar to the unbiased expectation formula, it will just have the liquidity premium added to it Revisiting An Earlier Example • Typo!! 1R2 should be 1R1 ○

•

○ ○

Investors want a reward for a longer-term investment, a premium for liquidity Shorter-term securities have greater return than long-term securities, therefore they charge a premium

Liquidity Premium Theory • Defined - LT interest rates are geometric averages of current & expected future ST rates plus liquidity risk premiums that increase with maturity • Greater uncertainty of security's future value for longer maturities • Shorter-term securities tend to have more active secondary markets ○ This gives shorter-term securities more liquidity ○ If you are lending longer-term, you are locking yourself into a security that has less liquidity so you require a premium • Shorter-term securities have less price risk • Investor "preference" for short- over long is based on liquidity not on any affinity for a specific maturity • Setting aside liquidity, securities of different maturities are perfect substitutes Unbiased Expectations (UET) vs Liquidity Premium Theory (LPT) • Differences in the yield curve

•

•

•

LPT "muddies the water" because when we observe a yield curve, we don't know how much of that tilt is because of expectations of future interest rates and how much of it is due to liquidity premium Overall.. If you see an upward sloping yield curve (especially steep), it is on account of expectations among investors that future short-term rates will be higher than current short-term rates

Market Segmentation Theory • Individual investors and financial institutions have specific maturity preferences (NB: Liquidity premium theory does not say this) ○ The market for funds is divided into different maturity segments with its own set of supply and demand conditions § The general shape of the yield curve is determined by these supply and demand conditions existing in these different market segments § E.g. decrease in supply of securities in the short-term market, & increase in supply of securities in the long-term market will make yield curve steeper • Interest rates are determined by distinct supply and demand conditions within various maturity segments • Investors and borrowers deviate from their preferred maturity segment only when adequately compensated to do so • Why maturity preference?? ○ Maturity preferences are often dictated by nature of liabilities on balance sheet (banks --> deposits; insurance cos --> life insurance contracts)

•

•

•

•

Unusual… you have a demand curve that is upward sloping ○ Don't let this worry you, the vertical axis doesn't have price, instead it is now yield percent(which is the inverse of price) and horizontal axis is quantity of short-term securities ○ DS = demand for short-term securities ○ DL = demand for long-term securities ○ Supply and demand in these segmented sections of the market for funds independently determine the short-term and long-term rate and the shape/slope of the yield curve ○ Supply of security means borrowing, a demand for funds § Rate is going to rise and fall with the supply curve/line § Example with graph: rates dropped for short-term securities, rates rose for long-term securities Main implication: calculated forward rates are not going to be unbiased estimates ○ The 9.38% is a biased expectation of future short-term rates Because of these considerations of people's preferences of specific market segments and therefore the supply and demand conditions existing therein or preference for short vs long-term securities, these forward rates that we can calculate.. They are not necessarily going to reflect purely what the market expects the future short-term rates to be "operation twist" - when the federal reserve steps in to make the yield curve flatter by selling short-term treasuries and purchasing long-term treasuring...