UNIVERSITY

Studies

MONEY AND CAPITAL

MARKET
Advance
OPEN

Lecture 5
IQBAL of

August 25th, 2015

Chenab College

Faisal Abbas
ALLAMA

faisalsialkml@yahoo.com

0
 UNIVERSITY
Studies

Today’s Class
Advance

• What is on today’s class Menu?

IQBAL ofOPEN

A. Recap
Chenab College

B. More about Economic Theories

ALLAMA

1
 UNIVERSITY
Recap
Studies

Introduction to Markowitz portfolio theory

Advance

Expected Return and Risk calculation

Measuring Portfolio risk
OPEN

Diversification
Choosing a Portfolio of risky Assets
IQBAL of

Economic Assumptions
Chenab College

Capital Market Theory

Introduction to William Sharp Capital Market Theory
The Capital Asset Pricing Model
ALLAMA

The Multifactor CAPM

Arbitrage Pricing theory Model

2
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

C
3
 UNIVERSITY
Studies
MARKET SEGMENTATION
THEORY
Advance
OPEN

A modern theory pertaining to interest rates stipulating

IQBAL of

that there is no necessary relationship between long

Chenab College

and short-term interest rates. Furthermore, short and

long-term markets fall into two different categories.
ALLAMA

Therefore, the yield curve is shaped according to the

supply and demand of securities within each maturity
length.

4
 UNIVERSITY
Studies
MARKET SEGMENTATION
THEORY
Advance

Also called the "Segmented Markets Theory", this idea

OPEN

states that most investors have set preferences

IQBAL of

regarding the length of maturities that they will invest

Chenab College

in. Market segmentation theory maintains that the

buyers and sellers in each of the different maturity
ALLAMA

lengths cannot be easily substituted for each other. An

offshoot to this theory is that if an investor chooses to
invest outside their term of preference, they must be
compensated for taking on that additional risk. This is
known as the Preferred Habitat Theory.
5
 UNIVERSITY
Studies
MARKET SEGMENTATION
THEORY
Advance

The yield curve is the relationship of the maturity to the bond yield
OPEN

mapped across different maturity lengths. The bond market pays close
attention to the shape of the yield curve. There are three main shapes
IQBAL of

of the yield curve: normal, inverted and humped. A normal yield

Chenab College

slopes upward slightly, with short-term rates lower than higher-term

rates. A normal yield curve shows that investors expect the economy
to keep growing. An inverted yield curve occurs when short-term
ALLAMA

interest rates are higher than long-term rates, and shows that investors
expect the economy to slow down as central banks tighten the
monetary supply. A humped yield curve shows mixed expectations
about the future, and may be a shift from the normal to inverted yield
curve.
6
 UNIVERSITY
Studies

Liquidity Premium Theory

Advance

Definition
OPEN

Suggests that since investors are risk averse, they will demand a
IQBAL of

greater premium for securities with longer maturity periods as

Chenab College

these are not easily convertible to cash on short notice.

A liquidity premium is usually added to the equilibrium interest
rate to determine the market rate of securities.
ALLAMA

7
 UNIVERSITY
Studies
Liquidity Premium Theory
Advance

LPT is a synthesis of both SMT and ET. It utilizes insights from

OPEN

both to explain the common phenomenon of long term yields

IQBAL of

being higher than short term yields. The explanation is simple:

Chenab College

the economy needs long term bonds as well as short term ones.
Investing in long term bonds is far more difficult because of
uncertainty -- the longer the term, the more uncertain the
ALLAMA

outcomes. Therefore, since long term bond holders keep their

money tied up longer, miss other short term opportunities and
face more uncertainty, the yield is better as compensation. This
is the "premium" in LPT.

8
 UNIVERSITY
Studies

Liquidity Premium Theory

Advance

Significance LPT serves as a market mechanism to encourage

OPEN

equilibrium between long and short term bondholders. This

IQBAL of

theory stresses that while the two types of bond are very similar,
Chenab College

they are not identical. LPT predicts that even if interest rates are
predicted to be flat, long term bonds will still yield higher
profits at the end of their term. If long term rates are expected to
ALLAMA

dip, then long term investors can expect to break even, or even
make a tiny profit. LPT serves to explain how this can be.

9
 UNIVERSITY
Advance Studies
The Term Structure of Interest Rates

The Yield Curve

OPEN

Spot and forward rates

IQBAL of

Theories of the Term Structure

Chenab College
ALLAMA

10
 UNIVERSITY
Studies
Term structure
• bonds with the same characteristics,
Advance
OPEN

but different maturities

• focus on Treasury yields
IQBAL of
Chenab College

– same default risk, tax treatment

– similar liquidity
ALLAMA

– many choices of maturity

 UNIVERSITY
Studies
Treasury securities
• Tbills:
Advance

– 4, 13, 26, and 52 weeks

OPEN

– zero coupon
IQBAL of

• Tnotes:
Chenab College

– 2, 5, and 10 years
ALLAMA

• Tbonds:
– 30 years (not since 2001)
• Tnotes and Tbonds are coupon
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
Treasury yields over time
 UNIVERSITY
Studies

• relationship between yield & maturity is NOT

constant
Advance

– sometimes short-term yields are highest,

OPEN

– most of the time long-term yields are highest

IQBAL of
Chenab College
ALLAMA
 UNIVERSITY
Studies

I. The Yield Curve

Advance

• plot of maturity vs. yield

OPEN

• slope of curve indicates relationship

IQBAL of
Chenab College

between maturity and yield

• the living yield curve
ALLAMA
 UNIVERSITY
upward sloping
Advance Studies

yield
IQBAL of
Chenab College OPEN

maturity
ALLAMA

• yields rise w/ maturity (common)

• July 1992, currently
 UNIVERSITY
Studies

downward sloping (inverted)

Advance

yield
IQBAL of
Chenab College OPEN

maturity
ALLAMA

• yield falls w/ maturity (rare)

• April 1980
 UNIVERSITY
Studies

flat
Advance

yield
IQBAL of
Chenab College OPEN

maturity
ALLAMA

• yields similar for all maturities

• June 2000
 UNIVERSITY
Studies

humped
Advance

yield
IQBAL of
Chenab College OPEN

maturity
ALLAMA

• intermediate yields are highest

• May 2000
 UNIVERSITY
Studies

Theories of the term structure

Advance

• explain relationship between yield and

OPEN

maturity
IQBAL of
Chenab College

• what does the yield curve tell us?

ALLAMA
 UNIVERSITY
Studies

The Pure Expectations Theory

Advance

• Assume:
OPEN

bond buyers do not have any preference

IQBAL of
Chenab College

about maturity
i.e.
ALLAMA

bonds of different maturities are perfect

substitutes
 UNIVERSITY
Studies
• if assumption is true,
then investors care only about expected return
Advance

– if expect better return from ST bonds, only hold

OPEN

ST bonds
IQBAL of

– if expect better return from LT bonds, only hold

Chenab College

LT bonds
ALLAMA
 UNIVERSITY
Studies

• but investors hold both ST and LT bonds

• so,
Advance

• must EXPECT similar return:

OPEN

LT yields =
IQBAL of
Chenab College

average of the expected

ST yields
ALLAMA
 UNIVERSITY
Studies

under exp. theory,

Advance

• slope of yield curve tells us direction of

OPEN

expected future ST rates

IQBAL of
Chenab College
ALLAMA
 UNIVERSITY
Studies

why?
Advance

• if expect ST rates to RISE,

OPEN

then average of ST rates will be >

IQBAL of
Chenab College

current ST rate
– so LT rates > ST rates
ALLAMA

– so yield curve SLOPES UP

 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

yield

maturity
ST rates expected to rise
 UNIVERSITY
Advance Studies

• if expect ST rates to FALL,

OPEN

then average of ST rates will be <

IQBAL of

current ST rate
Chenab College

– so LT rates < ST rates

– so yield curve slopes DOWN
ALLAMA
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

yield

maturity
ST rates expected to fall
 UNIVERSITY
Studies

• if expect ST rates to STAY THE SAME,

Advance

then average of ST rates will be =

OPEN

current ST rate
IQBAL of

– so LT rates = ST rates
Chenab College

– so yield curve is FLAT

ALLAMA
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

yield
same

maturity
ST rates expected to stay the
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

yield
fall

maturity
ST rates expected to rise, then
 UNIVERSITY
Studies

Is this theory true?

Advance

• not quite.
OPEN

• FACT: yield curve usually slopes up

IQBAL of
Chenab College

• but expectations theory would predict this

only when ST rates are expected to rise
ALLAMA

– 50% of the time

 UNIVERSITY
Studies
what went wrong?
Advance

• back to assumption:
OPEN

bonds of different maturities are perfect

IQBAL of

substitutes
Chenab College

• but this is not likely

– long term bonds have greater price volatility
ALLAMA

– short term bonds have reinvestment risk

 UNIVERSITY
Advance Studies

• assumption is too strict

OPEN

• so implication is not quite correct

IQBAL of
Chenab College
ALLAMA
 UNIVERSITY
Studies

Liquidity Theory
Advance

• assume:
OPEN

bonds of different maturities are imperfect

IQBAL of

substitutes,
Chenab College

and investors PREFER ST bonds

ALLAMA
 UNIVERSITY
Studies

• so if true,
investors hold ST bonds
Advance

UNLESS
OPEN

LT bonds offer higher yield as incentive

IQBAL of
Chenab College

higher yield = liquidity premium

ALLAMA
 UNIVERSITY
Studies

IF LT bond yields have a liquidity premium,

Advance

then usually LT yields > ST yields

OPEN

or yield curve slopes up.

IQBAL of
Chenab College
ALLAMA
 UNIVERSITY
Studies

Problem
Advance

• How do we interpret yield curve?

OPEN

• slope due to 2 things:

IQBAL of
Chenab College

(1) exp. about future ST rates

(2) size of liquidity premium
ALLAMA

• do not know size of liq. prem.

 UNIVERSITY
Studies yield curve
yield
small liquidity premium
IQBAL of Advance
OPEN

maturity
Chenab College

• if liquidity premium is small,

ALLAMA

• then ST rates are expected to rise

 UNIVERSITY
Studies
yield curve
yield
Advance

large liquidity premium

IQBAL ofOPEN

maturity
Chenab College

• if liquidity premium is larger,

ALLAMA

• then ST rates are expected to stay the same

 UNIVERSITY
Studies

Preferred Habitat Theory

Advance

• assume:
OPEN

bonds of different maturities are imperfect

IQBAL of
Chenab College

substitutes,
and investor preference for ST bonds OR
ALLAMA

LT bonds is not constant

 UNIVERSITY
Advance Studies

• liquidity premium could be positive or

OPEN

negative
IQBAL of
Chenab College

• yield curve very difficult to interpret

– do not know size or sign of liquidity premium
ALLAMA
 UNIVERSITY
Studies

Segmented Markets Theory

Advance

• assume:
OPEN

bonds of different maturities are NOT

IQBAL of
Chenab College

substitutes at all
ALLAMA
 UNIVERSITY
Studies

• if assumption is true,
– separate markets for ST and LT bonds
Advance

– slope of yield curves tells us nothing about future

OPEN

ST rates
IQBAL of

• unrealistic to assume NO substitution bet. ST

Chenab College

and LT bonds
ALLAMA
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

• unrealistic to assume NO substitution

 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

46