Theories of the yield curve

Question 1

Factors for yield curve

Answer 1

• Yield curve- plot of yield against term to redemption ( usually plots the gross redemption
  yield – but other yield such as spot rates -zero coupon bond yields- could be used )
• The factors give a feel into factors affecting
  o The shape of the yield curve
  o Interest rate risk management of bond portfolios
  o Pricing of interest rate sensitive derivatives

Question 2

Expectations theory:

Answer 2

o Driven by market expectations about the future short term interest rates
o If we expect the future short term interest rates to fall, we would expect gross
redemption yields to fall ( ends up being upward sloping curve )
o Change in shape of yield curve reflects changes in investor’s view of future interest
rates
▪ If we expect future short term interest rates to tall, then we would expected
the gross redemption yield to fall and the yield curve to slope downwards
o Short term interest rates are also influenced by inflation expectations
o If inflation is high, government is likely to force up the short term interest rates in
attempt to reduce inflation – and will want returns higher than inflation
o Upward sloping curve
▪ Reflects high inflation expectations and short term interest rates to be high

Question 3

Liquidity preference theory

Answer 3

o Based on general belief that Investors prefer liquid assets over illiquid assets
o Investors require higher returns to encourage them to commit funds for longer
period
o Longer dated stock are less liquid than short dated stock , so yields should be higher
for long dated stock due to the volatile prices that long dated bonds have
o Furthermore , it states that the yield curve should have slope greater than the one
predicted by the pure expectation theory

Question 4

Inflation risk premium theory (applied to fixed interest bonds only)

Answer 4

o Applies to investors with real liabilities and purchasing fixed interest bonds leads
to mismatching risk
o Investor buying a conventional bond and holding it to maturity is locking into a
known rate of nominal return – ignoring the reinvestment of coupons
o However investors are interested in the real return than the nominal returns
o Investors should therefore require higher nominal yield to compensate for the risk
that inflation is higher than expected and real return is lower than expected
o The uncertainty about future inflation is greater over long periods
o Risk premium should be higher for longer dated bonds to compensate investors
o Theory assumes that investors have real liabilities ( liabilities that change with
inflation or index) – causing mismatching risk with conventional bonds
o Yield curve slopes upwards always
▪ This is done to compensate investors for holding long dated bonds which are
more vulnerable to inflation risk than shorter dated bonds

Question 5

Market Segmentation theory

Answer 5

o Yields at each term to redemption are determined by supply and demand from
investors with liabilities of that term
o Fundamental ideas in which market segmentation is based on
▪ Different providers and investors have different needs
* liabilities of different terms , so they are active at different terms of
the yield curve
▪ Price is a function of supply and demand , and yields are functions of price
▪ Supply will wish to supply investments of different terms , so will be more
active at different terms of the yield

Question 6

Comparison of government and corporate bond yields

Answer 6

• Differences in marketability
• Default risk
• Economy status – recession or not
• Availability of government bonds
• Price of government debt
  o Offering poor returns compared with high quality debt
• Equity market conditions
  o If they are depressed , they will find it easy to issue corporate debt
  o Oversupply will depress prices and increase yields
• Size of company and collateral availability
• Credit rating of company