Question

1. Assess the following claims as either “True”, “False” or “Uncertain” and briefly explain your response:

(a.) “Assuming that the expectations theory of the term structure is true, if the market believes that interest rates are likely to decrease in the near future borrowers would immediately increase their supply of shortterm securities.”

(b.) “Assume you have a collection of municipal bonds and corporate bonds of similar maturities and default risk (i.e. both sets of bonds carry a rating of “AA+” from Standard and Poor’s). Accordingly, a yield curve formed from municipal bonds will be higher than a yield curve formed from the corporate bonds because of their tax-advantaged status.”

2. explain: (i.) The primary difference between the expectations theory of the term structure and the liquidity theory of the term structure, and (ii.) Why forward rates are biased predictors of future short rates if the liquidity theory holds.

Answer 1

1 . (a) False. If the market expects the interest rates to decrease, the borrowers will wait for the rates to decrease before they inrease the supply of short term securities, to avail the benefit of lower rates. This would mean a lower supply and assuming the demand stays at same levels, the expectation will materialise with lower supply relative to demand leading to lower rates in near future.

(b). True. The yield curve is plotting of interest rates vs maturity of similar bonds. Similar bonds (mostly treasuries) are used so that all other factors like credit risk, taxation and liquidity issues are same & kept constant - hence it is almost true reflection of the relationship between the interest rates and maturities.

2 (i) The primary difference between the expectations theory (ET) and liquidity theory (LT) is that ET postulates investors have no preference or bias across different maturities (& resultant risks) whereas LT specifically states that investors require to be compensated for longer term maturities.

(ii) The LT presumes an interest rate premium for longer tenures in addition to the future expecation of rates. Hence it assumes an upward sloping yield curve however unlike under ET where under no arbitrage condition, we can work out future short term rates from forward rates, it is not exactly the same under LT since the forward rates are not pure expecation of interest rates but also include premium for longer tenure . Due to this the future short term rates when calculated from forward rates under LT are not true reflection of expected rates. Hence it is also sometimes called as biased expection theory.