Question

W4A2 FINANCE:

In this part of your Course Project, you will research and analyze current information (that is, within the past two months and current info of your choice) on government securities.

Research current information (within the last two months) on the yields and maturity for: US Treasuries, Municipal Bonds, and Corporate Bonds.

Tasks:

Analyze what the pure expectations theory would imply about the yield curve for each security.

Evaluate the yields and maturities for each of the securities.

Justify which you would hold and why, relative to interest rate risk.

PS: The information provided above are all that I have for this assignment. Please do not sent it back requesting for "more info". Thank you!

Answer 1

Under the unbiased expectations theory or the pure expectations theory, we
hypothesize that it is investors' expectations that determine the shape of the interest rate
term structure. Specifically, this theory suggests that forward rates are solely a function of expected
future spot rates, and that every maturity strategy has the same expected return over
a given investment horizon. In other words, long-term interest rates equal the mean
of future expected short-term rates. This implies that an investor should earn the same
return by investing in a five-year bond or by investing in a three-year bond and then a
two-year bond after the three-year bond matures. Similarly, an investor with a three-year
investment horizon would be indifferent between investing in a three-year bond or in
a five-year bond that will be sold two years prior to maturity. The underlying principle
behind the pure expectations theory is risk neutrality: Investors don't demand a risk
premium for maturity strategies that differ from their investment horizon

So for last 2 months US treasuries yeild is ~2.50% for 10 year maturity.

For 10 year maturity municipal bond yeilds 1.80%

For 10 year maturity corporate bond (Investment grade) yeilds 3.40%

I prefer to invest in US treasuries as this is safer instrument than Corporate bonds (More credit risk in corporate risk) even though they have lesser return as compare to corporate bond. Tresuaries are backed by US government