CH 06
CH 06
CH 06
it + iet+1
i2t =
2
© 2005 Pearson Education Canada Inc. 6-13
Expected Return from Strategy 1
More generally for n-period bond:
it + iet+1 + iet+2 + ... + iet+(n–1)
int =
n
In words: Interest rate on long bond = average short rates expected to
occur over life of long bond
Numerical example:
One-year interest rate over the next five years 5%, 6%, 7%, 8% and
9%:
Interest rate on two-year bond:
(5% + 6%)/2 = 5.5%
Interest rate for five-year bond:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
Interest rate for one to five year bonds:
5%, 5.5%, 6%, 6.5% and 7%.
© 2005 Pearson Education Canada Inc. 6-14
Expectations Hypothesis
and Term Structure Facts
Explains why yield curve has different slopes:
1. When short rates expected to rise in future, average of future short
rates = int is above today’s short rate: therefore yield curve is upward
sloping
2. When short rates expected to stay same in future, average of future
short rates are same as today’s, and yield curve is flat
3. Only when short rates expected to fall will yield curve be downward
sloping
Expectations Hypothesis explains Fact 1 that short and long rates
move together
1. Short rate rises are persistent
2. If it today, iet+1, iet+2 etc. average of future rates int
3. Therefore: it int , i.e., short and long rates move together
Doesn’t explain Fact 3 that yield curve usually has upward slope
Short rates as likely to fall in future as rise, so average of future
short rates will not usually be higher than current short rate:
therefore, yield curve will not usually slope upward