Economics, Money Markets and Banking

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Economics, Money Markets and Banking Lecture 5
Yield Curves and Interest Forecasts
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• Yield Curve (Term Structure of Interest Rates)
  Basics
• 1. What is the Yield Curve?
• Interest rates on financial instruments vary
  because of default risk, liquidity risk,
  call provisions, etc.
• Holding all the above constant, it also
  appears rates vary because of maturity. The
  relationship between interest rates and
  maturity, all else fixed, is called the
  term structure of interest rates or the yield
  curve.
• Where do we find the yield curve?
• Typical yield curve.

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Note downward sloping when rates
high Flatter when rates moderate Upward
sloping when rates low
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• Determinants of the Yield Curve Shape
• A. Segmented Markets View independent markets
• i S i
  S
• .10
• D D
  Short-term funds Long-term funds
• Players Fed Banks Insurance/pension companies
• Instruments T-bills, commercial paper Mortgages,
  bonds, note

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Implied Yield Curve i .10 1
30 maturity Operation Twist (early 1960s)
To raise short rates and lower long rates
Fed was to sell bills and buy bonds.
.12
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Implied Yield Curve i .10 1 30
maturity Operation Twist (early 1960s)
To raise short rates and lower long rates
Fed was to sell bills and buy bonds.
Fed sold T-bills from its portfolio. This should
lower T-bill prices and raise short term
rates. Fed then purchased long term Treasury
Securities, trying to drive long term debt
prices up, and long rates down.
.12


.08

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• Pure Expectations View (sometimes called the
  Rational Expectations View)
• Example Suppose an investor has a two-year time
  horizon (holding period). Suppose further that
  1-year and 2-year deposits exist. Suppose
  further that the current 1-year rates is 4 and
  the depositor thinks the 1-year rate one year
  from now will be 10. What rate would you have
  to offer to get this depositor to put money in a
  2-year deposit.
• What does the depositor expect to make on two
  1-year deposits? (Lets ignore compounding).
• First year return expected second year return
• .04 .10 .14 14

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What would seller of 2-year deposit have to
offer to attract a buyer? R2 R2 .14 2
R2 .14 R2 .07 7
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• Implications for Yield Curve
• Example shows that the 2-year rate will end up
  being roughly the average of the current 1-year
  rate and the expected 1-year rate, i.e.,
• This implies that the yield curve is drawn for
  some market expectation of short-term rates in
  the future.
• i
• Yield curve given the
• .07 Market thinks the 1-year
• rate next year is going to be
• .04 10
• 1 2 maturity

• What if This Doesnt Hold ?
• If R2 lt 7, nobody will buy 2yr Bonds. Price will
  fall, rate will increase
• If R2 gt 7, everybody will buy 2yr Bonds. Price
  will Rise, rate will fall

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This implies that the expected future
direction of rates is embedded in the yield
curve. To see this, what if the market thinks
the 1-year rate next year will be 4 or
20? I .12 If 1-year rate next year
expected to be 20 .07 If 1-year rate next
year expected to be 10 .04 If 1-year rate
next year expected to be 4 .03 If 1-year
rate next year expected to be 2 1 2 maturity
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• Conclusion (compare to picture of typical yield
  curve)

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? Formal yield curve forecasts Let Ri
current known rate from the WSJ on i
period Investments tFi forward rates
markets guess of rate on i period
investments, t periods from now  Then, 2R2 R1
1F1 (invest in a 2 yr, or two 1 yrs)
3R3 R1 21F2 (invest in a 3 yr, or a one
and a two) 3R3 2R2 2F1 (invest in a 3 yr,
or a two and a one)   Solutions  
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Example Yield Curve on June 28, 2005 R1
.0346 R2 .0366 R3 .0369 What does the
market think the 1-year rate will be in July
2006? 2 R2 R1 1F1 1F1 2 R2 - R1
2(.0366) - .0346 .0386 Last year 1F1
.0304 What does the market think the 1-year rate
will be in July 2007? 3R3 2R2 2F1 2F1
3(.0369) - 2(.0366) .0375
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• Two Applications in Banking
• Riding the yield curve
• Loan interest swaps

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• Yield Curve Games
• A. Riding the Yield Curve for Fun and Profit
• Basic idea Assuming a positively sloped
  yield curve, purchase a security with a
  maturity longer than your expected holding
  period.
• Rationale You will make money because 1)
  longer maturities pay higher rates, 2) when
  you sell it in the security will have a
  shorter maturity, hence lower rates, hence a
  capital gain.
• Yield
• .07
• .04
• 1 2 maturity (years)

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Example You want to invest for 1 year.
Current 1-year rate is 4, 2-year rate is
7. -- If you buy 1-year security make 4 --
If ride, price per dollar of face of 2-year
security is .8734. If sell in one year
when 1-year rate is 4, get .9615
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Will this work in an efficient
market? -- What will you be able to sell the
security at next year? The market expects the
rate on 1- year securities to be 10. This
implies the price will be .9090. NOTE
You will make money riding the yield curve as
long as the 1-year rate next year turns out to
be less than the market forecast. If the rate
turns out to be more than the market forecast,
you will lose money. The market forecast is a
breakeven rate.
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What if 1 year rate next year ends up 14 !
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If positive, market overestimated what rates
would be, i.e. rate ended up less than the market
expected.
Rates went up more than the market thought ! i.e
got burned is you rode (markets underestimated
inflation)
Article recom -mands riding !
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LIBOR SWAPS Suppose the banker wants to receive
variable rate interest, but the customer wants to
pay fixed. Impasse! No Deal? Solution Let the
customer pay fixed, then swap the fixed for Libor
(variable) in the interest swap market. The curve
on the next page says the market will trade about
4 fixed for two years (4 fixed each year) for 3
month Libor each quarter for two years.
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How does the market come up with this tradeoff?
(Lets use annual Libor for simplicity)
Then market will add a risk premium in case
customer defaults.
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Real World Suppose a customer knows that the
market typically overestimates short-term
rates. In our example, suppose customer thinks
rate next year on 1 year stuff is going to be 8,
not 10. Then, they will prefer the variable to
the fixed, because 4 8 lt 7 7. This is
what is happening a lot in our local banks even
though fixed rates are so low.
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• Interest Forecasting
• There are three ways to forecast interest rates.
• Roll your own
• Nominal rate real rate
  expected inflation
• Forecast Real GDP Forecast inflation
• Use implied forward rates
• Look at the futures market
• Suppose you (I) think a bushel of corn will sell
  for 100 a year from now. Would you agree now to
  sell it to me then for less than 100? Would I
  agree to pay more than 100 ?
• So, the price will end up being close to our
  best guess of the price.
• Same is true for the t-bills, fed funds, bonds.

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