Question

Your friend Mark is quite worried about the recent volatility in equity markets due to the current health pandemic and is thinking about investing in the bond market. He contacts you to seek your advice on bond markets. You have undertaken some research and find the following information regarding yield on different bonds. (i) 1.8% current one-year bond

(ii) 1.9% expected one-year bond rate in 24 months’ time

(iii) 1.93% three-year bond rate

a) Using the pure expectations theory advise your friend on the yield he should expect on a one-year bond in 12 months’ time.

b) Identify and explain to your friend two assumptions of the pure expectations theory that are challenged by the segmented markets approach to interest rate determination.

c) Your friend has heard that inflation is anticipated to rise significantly over the next few years. Explain to him what effect would this expected rise in inflation have on the slope of a normal yield curve? Also, what effect, if any, this change in inflation will have on the value of his bond investments?

Answer 1

a) From Expectations hypothesis, if two year rate is r, then

(1+r)^2*1.019 = 1.0193^3

=> r = 0.01945 or 1.945%

Now, the yield on a one-year bond in 12 months’ time = 1.01945^2/1.018 -1 = 0.020902 or 2.09%

b) Pure Expectations theory that future long term rates can be determined completely from the short term rates and the expected interest rates after the short term period till the long term period. This is challenged by the segmented approach which says that there are different markets for long term and short term rates

another difference is that in Expectations theory, the market is viewed as a whole whereas Segmentation theory says that there are distinct segments in the market with each one having its own supply demand dynamics

c) Increase in Inflation increases the required rate of return from bonds (i.e. increases the yields) and shifts the yield curve upwards

Also as the required rate of return increases, the value of bonds will decrease (as value is inversely related to yields) and hence the value of his bond investments will decrease