Term Structure: Theoretical Challenges

Research Evidence A number of studies reject the unbiased expectations hypothesis and find that the yield curve does not have significant predictive power in forecasting interest rates. –(Shiller, Campbell and Schoenholtz, 1983, Campbell 1986, and Mankiw 1986). Other studies, however, find evidence consistent with the unbiased expectations hypothesis. –Froot 1989, Longstaff 1990, Fama and Bliss 1987, and Sargent 1982).

Research Evidence: Examples Froot (1989) –The expectations hypothesis does not work for short maturities but for long maturities the yield curve moves point for point with changes in expected future rates. Fama (1984) –Fama finds that the term structure can be used to forecast one-month interest rates one month ahead. Fama and Bliss (1987) –Fama and Bliss find that one year forward interest rates can forecast changes in the one year interest rate two to four years in advance.

More Research Evidence: Liquidity Premiums Kiely, Kolari, and Rose (1994) found that liquidity premiums vary over time, rising and falling with the business cycle. They argue that the premiums arise from two opposing forces: –The price-risk hypothesis –The money-substitutes hypothesis

Price-Risk Hypothesis The price-risk hypothesis claims that liquidity premiums are inversely related to the level of market interest rates. –When interest rates fall below the level that investors regard as normal, the public will begin to expect rising interest rates and to anticipate greater losses on long- term bonds. –As a result, they will demand larger liquidity premiums on longer term securities.

Price-Risk Hypothesis The price-risk hypothesis claims that liquidity premiums are inversely related to the level of market interest rates –When interest rates rise above the level that investors regard as normal, the public will begin to expect falling interest rates and to anticipate greater gains on long-term bonds. –As a result, they will demand smaller liquidity premiums on longer term securities.

Money-Substitutes Hypothesis The money-substitutes hypothesis suggests that a direct relationship exists between liquidity premiums and the level of interest rates. –Interest rates represent the opportunity cost of holding money and the higher cash balances are, the greater the lost potential income or opportunity cost. –We know that risk averse investors prefer to place their cash in short-term securities because the longest-term securities carry the greatest price risk.

Money-Substitutes Hypothesis –Therefore, as market rates rise, investors shift a portion of their cash balances into short-term securities to avoid suffering the higher opportunity costs of holding idle cash. –The added demand for short-term securities generates a more positively sloped yield curve as the liquidity premiums on long-term securities become larger relative to liquidity premiums on short-term securities.

Money-Substitutes Hypothesis Consequently, a rising level of interest rates can lead to higher liquidity premiums and a more steeply sloped yield curve while a falling level of interest rates can lead to lower liquidity premiums and a flatter or downward sloping yield curve. Kiely, Kolari, and Rose found that the price-risk hypothesis tends to be more significant in low interest-rate periods, but the money-substitutes hypothesis is more important when interest rates are relatively high.