1. Yield curves almost always slope upwards.

One of the reasons for this is

the high demand for short term bonds. Name and explain three reasons
why most investors would prefer short term bonds. (6)
 Uncertainties in future inflation .Uncertainty about future inflation
will create uncertainty about the real return. The further the future, the
higher the uncertainty about the inflation level. So long-term bonds
contain higher inflation risk than short-term bonds.
 Interest Rates Risk. The longer the maturity of the bond, the greater
the uncertainty about the future bond price. Thus, it is riskier to hold a
long-term bond relative to a short-term bond
 Price change. Bonds with longer terms have greater chance of
experiencing price changes with the movement in interest rates
 most investors may not want to lock up their funds for a longer period
and thus would take advantage of the greater liquidity of short-term
bonds
2. Briefly discuss one of the theories of the term structure of interest rates
that do not cover all three facts. Include the advantages/disadvantages in
comparison to the other theories
Expectation Hypothesis: The key assumption behind this theory is that buyers
of bonds do not prefer bonds of one maturity over another, so they will not
hold any quantity of a bond if its expected return is less than that of another
bond with a different maturity. Bonds that have this characteristic are said to
be perfect substitutes. The expectation hypothesis (or the expectations theory)
implies that the interest rate on a long-term bond will equal an average of the
short-term interest rates that people expect to occur over the life of the long-
term bond.
Advantage(s) of the expectation hypothesis: (1) It can be used to explain Fact
1-interest rates of different maturities tend to move together (in the same
direction) - If the short-term interest rates decrease (increase), long-term
interest rates will also decrease (increase) (2) It explains Fact 2 well as well- i.e.
when short-term interest rates are low, yield curves are more likely to have an
upward slope; and when short-term rates are high, yield curves are more likely
to slope downward and be inverted.
Disadvantage(s) of the expectation hypothesis: it cannot however explain Fact
3, i.e. it cannot explain why most of the time the yield curve slopes up.
. OR
Segmented Markets Theory: Unlike the expectations hypothesis, this theory
assumes that investors regard markets for bonds of different maturities as
completely separate, or segmented. That is, bonds of different maturities are
not substitutes at all. Subsequently, if bonds of different maturities are not
substitutes at all, then the interest rate for each maturity is determined solely
by the supply of and demand for bonds of that maturity, with no effects from
interest rates on bonds of other maturities.
Advantage(s): Segmented markets theory can explain Fact 3. If most investors
prefer short-term bonds, the demand for short-term bonds will be greater
than the demand for long-term bonds. This implies that short-term rates would
be lower than long-term rates, making the yield curve sloping upward.
Disadvantage(s) – (1) Segmented market theory cannot explain Fact 1: If bonds
of different maturities are really traded in completely separated markets and
are not substitutes at all, then their interest rates should show no tendency to
move together. (2) The theory cannot explain Fact 2: Unless we assume that
investors preferences for bonds of different maturities changes significantly
over time, so that they sometimes prefer short-term bonds and sometimes
prefer long-term bonds. Page 10 of 12
3. Mathematically explain the difference between the three theories of term
structure of interest rates. (4)
 Empirical example: If one-year interest rates over the next five
years are expected to be 5%, 6%, 7%, 8% and 9%, equation two
indicates that the interest rate on the two-year bond will be;
e
i t +i t+1 5 %+ 6 %
• i 2 t= = =5.5 %
2 2
•
On the five-year bond, it will be;
𝑖_5𝑡=(5+6+7+8+9)/5=7%
By doing similar calculations for the one-, two-, three-, four-year interest
rates, you should be able to verify that the one- to five-year interest rates
are 5%, 5.5%, 6%, 6.5% and 7% respectively.
Thus, we see that the rising trend in expected short-term interest rates
produce an upward-sloping yield curve along which rates rise as maturity
lengthens.

Expectation hypothesis short- and long-term interest rates relationship

With the liquidity premium theory, the equation above is modified to

If investors prefer short-term bonds, then the liquidity/term premium (𝑙_𝑛𝑡)
will be positive and increases as ‘n’ increases.
Suppose that the one-year interest rates over the next five years are expected
to be 5%, 6%, 7%, 8% and 9%, while investors preferences for holding short-
term bonds means that liquidity premiums for one-to five-year bonds are 0%,
0.25%, 0.5%, 0.75% and 1% respectively. Equation (3) indicates that the
interest rate on the two-year bond would be;

Segmented Markets Theory

This theory assumes that investors regard markets for bonds of different
maturities as completely separate, or segmented. That is, bonds of different
maturities are not substitutes at all.
Examples:
If you are planning to go in vacations for next year, you will prefer to save in a
1-year maturity bond (Investors saving for a short period of time buy only
short-term bonds)
But someone saving for retirement may prefer investing in a long-term bond
(Investors saving for a long period of time buy only long-term bonds)
If bonds of different maturities are not substitutes at all, then the interest rate
for each maturity is determined solely by the supply of and demand for bonds
of that maturity, with no effects from interest rates on bonds of other
maturities.
Segmented markets theory can explain Fact 3. If most investors prefer short-
term bonds, the demand for short-term bonds will be greater than the demand
for long-term bonds.
Hence, the interest rate on short-term bonds will be lower than the interest
rate on long-term bonds.
That is, the yield curve will typically slope upward.
4. Explain how the central bank uses market expectations to influence long
run interest rate (like mortgage loan interest rates) and briefly explain the
motive for the central bank to influence long run interest rates. (5)
Expectations about the path of future monetary policy would then help to
determine the final impact of this policy on the long-term interest rates.
The central bank can guide (and convince) the public about its future policy
path by pre-announcing the policy future actions in order to achieve better
results but it all depends on its credibility in the market.
If the market believes the announced policy path, the central bank can easily
achieve a desired result.
Otherwise, monetary policy will be ineffective in affecting long-term rates and
the aggregate demand.
Managing public expectations is then part of the monetary policy strategy and
expectations depend on the central bank credibility.
5. Kiribati a small developing country has experienced low levels of their
5-year treasury rates in recent years explain how the risk structure of
interest rates and the term structure of interest rates could have
contributed to these low-level interest rates
Kiribati interest rate might be high due to
Risk structure
Low Risk of government bonds (higher possibility to default)
More traded (more liquid)
Might now hold tax benefits
Term structure
The risk of time is low (meaning expectation about the future is
sound)
 6.

Municipal bonds became more risky, less liquid (less traded) or have less tax benefits than corporate
bonds (Students can also write in terms of corporate bonds which will then just be the opposite)