1. Chapter 7: Learning Objectives Term Structure of Interest Rates

2. Chapter 7: Learning Objectives Term Structure of Interest Rates expectations & other hypotheses

3. Chapter 7: Learning Objectives Term Structure of Interest Rates expectations & other hypotheses real interest rate considerations

4. Chapter 7: Learning Objectives Term Structure of Interest Rates expectations & other hypotheses real interest rate considerations Anomalies in the yield curve

5. Long-term and short-term Government of Canada Bond Yields

6. The Term Structure of Interest Rates: The Expectations Hypothesis Why hold short-term vs. Long-term bonds? Should their yields be linked to each other? R1R1 R2R2 E11E11

7. The Key Relations in the Expectations Hypothesis The Simplest case: R 2 = (R 1 + E 1 1 )/2 The General case: R n = (R 1 + E 1 1 + E 2 1 + … + E n-1 1 )/n

8. The Expectations Hypothesis: Two Examples R2R2 5=(4+6)/2 R1R1 414 E11E11 613 E12E12 12.5 E13E13 12 E14E14 11.5 R5R5 12.6=(14+13 +12.5+12+11.5)/5

9. Hypothetical Yield Curves Term Yield Rising Constant Falling

10. Financial Focus 7.1 Hypothetical YC are an estimate of the relationship between yield and term to maturity Term Yield

11. Financial Focus 7.1 Hypothetical YC are an estimate of the relationship between yield and term to maturity Yield curves must be constructed for similar types of financial instruments Term Yield

12. Financial Focus 7.1 Hypothetical YC are an estimate of the relationship between yield and term to maturity Yield curves must be constructed for similar types of financial instruments One must not read too much into the shape/slope of a yield curve Term Yield

13. Yield Curve Puzzles The Yield curve is generally upward sloping

14. Yield Curve Puzzles The Yield curve is generally upward sloping Table 7.3 shows that the term premium is generally positive

15. Table 7.3: Yield differential relative to 90-day treasury bills

16. Yield Curve Puzzles The Yield curve is generally upward sloping Table 7.3 shows that the term premium is generally positive The yield curve tends to shift over time

17. Yield Curve Puzzles The Yield curve is generally upward sloping Table 7.3 shows that the term premium is generally positive The yield curve tends to shift over time Figure 7.3 shows that inflation tends to shift the entire yield curve

18. Shifting Yield Curves

19. Yield Curve Puzzles The Yield curve is generally upward sloping Table 7.3 shows that the term premium is generally positive The yield curve tends to shift over time Figure 7.3 shows that inflation tends to shift the entire yield curve The slope of the yield curve tends to predict future economic activity

20. Yield Curves and Monetary Policy

21. Figure 7.4: Shifting yield curves

22. Figure 7.5: The yield spread and recessions in Canada

23. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: COUNTERPOINT:

24. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand COUNTERPOINT:

25. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good COUNTERPOINT:

26. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies COUNTERPOINT:

27. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT:

28. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes

29. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant

30. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant Empirical evidence for EH weakest for US

31. POINT-COUNTERPOINT 7.1: The Information Content in Yield Curves POINT: The YC is easy to understand At maturities of <= 3 yrs inflation forecasting performance is good Useful pedagogical device to understanding central bank policies Helps to understand debt management COUNTERPOINT: LT and ST bonds are not good substitutes Transactions costs can be significant Empirical evidence for EH weakest for US Ignores many other factors that determine yields over time

32. Competing Explanations of the Term Structure The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner

33. LIQUIDITY PREMIUM

34. Competing Explanations of the Term Structure The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner The Market Segmentation theory: Short-term and long-term markets are separate

35. MARKET SEGMENTATION

36. Competing Explanations of the Term Structure The Liquidity Premium theory: Holding longer term bonds in inherently riskier because the market is thinner The Market Segmentation theory: Short- term and long-term markets are separate The Preferred-Habitat theory: there is limited substitutability between short-term and long-term bonds

37. Figure 7.7: Interest rates and the maturity structure of government of Canada debt

38. Summary The term structure of interest rates explains why interest rates differ when their term to maturity differs

39. Summary The term structure of interest rates explains why interest rates differ when their term to maturity differs The expectations hypothesis predicts that long term rates are averages of expected short-term rates

40. Summary The term structure of interest rates explains why interest rates differ when their term to maturity differs The expectations hypothesis predicts that long term rates are averages of expected short-term rates Despite the appeal of the expectations hypothesis there are “puzzles” in the behaviour of the yield curve