EH true vs wrong - Lecture notes 18 PDF

Preview

Summary

This course has many lectures that will help you excel your midterm and final, I got an A in this class...

Description

EH true vs wrong True • • • •

Suppose the 1 year rate is 5%, the two year rate is 6%. What does this mean for the expected 1 year rate one year from now? Suppose the two year rate is 4% instead. The EH says: if long rate is higher than short rate, it’s because short interest rates are expected to rise Consider the current Yield Curve

Wrong

•

• •

Term structure almost always slopes upward • If the EH is the only thing going on, this means that expected future short rates are almost always higher than current short rates Obvious flaw: people don’t care only about expected returns, they also care about risk Let’s see what happens if investors care about risk

What did EH give us •

• •

One possible reason why long rates (e.g., the 2 year rate) are higher than short rates (eg the 1 year rate): • Next year's short rate is expected to be higher Let's control for that • Let's assume that short rates are not expected to change But now, let’s assume that investors care about risk

LONG •

• •

•

Investor LONG has two options • Invest in the two year bond, hold till maturity. • Invest in the one year bond, hold till maturity, and then invest in the one year bond at that time. What does she make on each? Which side has risk? • Which does she dislike more? • Suppose short rates are not expected to change… If all investors are like her, what is the relationship between the two year rate and the one year rate?

•

Even when the 1 year rate is expected to be constant, the term structure is downward sloping

Short •

•

•

•

Investor SHORT has two options • Invest in the one year bond, hold till maturity. • Invest in the two year bond, hold for one year, then sell If the expected one year interest rate one year from now is E(r1,2), how much does she expect to make on the second option? • Price today of bond paying $100 in two years: • Expected price one year from now, of bond paying $100 in two years: • Her HPR: Which side has risk? • Which does she dislike more? • Suppose short rates are not expected to change… If all investors are like her, what is the relationship between the two year rate and the one year rate? • Even when the 1 year rate is expected to be constant, the term structure is upward sloping...