Lecture - Expectation hypothesis and Liquidity premium theory PDF

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Expectation hypothesis and Liquidity premium theory...

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Procedure for report 2, 3 (FDIC) Reference to peer banks (mark deducted if not) Reference is important

Change in yield Change in bond price and associated change in interest rate Credit rating agencies (CRAs) Default risk for bondholders, they require financial compensation Reliable credit risk assessment by CRAs Dodd-Frank Wall Street Reform and Consumer Protection Act reduce reliance on CRAs Speculative grade bonds (companies or countries have difficulty meeting bond payment, but not at risk of default) Junk bonds (High yield and large risk) - Fallen angels (once investment-grade bonds, but issuers fell on hard times) Lower rating higher yield Residential mortgage: subprime (not meet the standard of creditworthiness) Helped trigger the financial disruption 2007 - 2009 Large, highly leveraged FI held a sizable volume of MBS backed by subprime mortgage

Commercial paper: short term bond Borrower offer no collateral Discount basis, zero-coupon bond, future payment no associated coupon payment Maturity less than 270 days Low rating higher default risk so lower price and higher yield → increasing cost of funds Bond yield = US treasury yield + default risk premium Lower rating, higher default-risk premium Term structure of interest rates

Expectations hypothesis: Approximate two year bond rate by average 1. Interest rates of different maturities will move together 2. Yields on short term bonds will be more volatile (long term rates are average of shortterm rates) 3. Long-term yields tend to be higher (interest rates always expect to rise, which is not true)

Interest rate risk: mismatch between investor’s investment horizon and bond’s time to maturity If bondholder sell a bond before maturity, changes in interest rate generates capital gain or loss.

Default -free bonds are risky because of uncertainty about inflation and future interest rates. Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk. Bondholders care about the purchasing power of the return—the real return—they receive from a bond, not just the nominal dollar value of the coupon payments. Liquidity premium theory of the term structure of interest rate Two parts: risk free explained by expectation hypothesis + risk premium Term structure of interest rate is consistent with expectation hypothesis and liquidity premium Term structure is good indicator of future economic performance

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