Week 3 Expectation Theory PDF

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Expectation theory - what do investors expect?...

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Expectation Theory • Strategy 1- Buy a bond that matures in 2 years • Strategy 2-Buy one year bond, then a another one year bond • Suppose the rate of one year bond is 10% and the expected rate on one year for next year 12% • What should be the rate on the two year bond? 2

1  r   1  r 1  r (0)

2

(0) 1

(0, E (1) 1



 1.10 1.12  1

r2   1.10 1.12   2  1  0.1099  11%

Market segmentation theory • What it is: • Market segmentation theory posits that the behavior of short-term and long-term interest rates are mutually exclusive. • How it works (Example): • Market segmentation theory suggests that the behavior of short-term interest rates is wholly unrelated to the behavior of long-term interest rates. In other words, a change in one is in no way indicative of an immediate change in the other. Both must be analyzed independently. Accordingly, the yield curve reflects the market supply and demand for Treasury bonds of a certain maturity only. • Why it Matters: • Market segmentation theory suggests that it is impossible to predict future interest rate outcomes based on short-term interest rates. Moreover, longterm interest rates (for example, the rate of the 30-year Treasury bond) only express market expectations and do not indicate that a definite outcome will occur.

Liq Liqu uid idiity prefer ere enc nce e • Liquidity preference, in economics, the premium that wealth holders demand for exchanging ready money or bank deposits for safe, nonliquid assets such as government bonds. As originally employed by John Maynard Keynes, liquidity preference referred to the relationship between the quantity of money the public wishes to hold and the interest rate. According to Keynes, the public holds money for three purposes: to have on hand for ordinary transactions, to keep as a precaution against extraordinary expenses, and to use for speculative purposes. He hypothesized that the amount held for the last purpose would vary inversely with the rate of interest....