Fixed-Income Securities:

Shape of the Yield Curve

1
Current Yield Curve

2
 What explains the shape of the yield curve?

1. Expectation Hypothesis
2. Liquidity Preference Theory
3. Segmented Markets

3
 1. The Expectations Hypothesis
 Assumptions:
 No transaction costs.

 No default.

 Investors maximize profits; they are risk-

neutral.
 All bonds are zero-coupon bonds.

 Implication of risk-neutrality: Investors choose

the maturity of their bonds to maximize holding
period returns.

4
Two year investment : compare 2 alternatives for a
risk-neutral bond investor

1)Invest in 2 yr zero coupon bond

2)Invest in 1 yr zero. Then in 1 year you reinvest the

money received in a new 1 yr zero at whatever yield
prevails in 1 year.

Under (1) E(1+HPR) = (1+Yt (2))2

Under (2) E(1+HPR) = (1+Yt(1))(1+E(Yt+1 (1))

5
Then 

(1+Yt(2))2 = (1+Yt(1)) * (1+E(Yt+1 (1))

Compare with forward rates :

(1+Yt(2))2 = (1+Yt(1)) * (1 + ft(1))

Under risk neutrality (Expectations hypothesis)

ft(1) = E(Yt+1 (1))

6
 Main Insights
 The long term rate is a geometric average of current and
expected future short rates.

1  yt (2)  1  yt (1)1  Et yt 1 (1)

1
2

 Proof: see handouts.

 All expected HPR are equalized in equilibrium.
 Typical shape of yield curve is flat.
 Short-term interest rates are more volatile than long-term
interest rates.
 What does an upward-sloping yield curve, i.e. y(2) > y(1), imply
about the expected future short-term interest rate?

7
 Historical Yields: October 2013

Why were the 1 month yields higher than 3 months yields?

8
Historical Yields: January 2007

9
Historical Yields

10
 Markets: Historical Yield Curves

 US 11/2012: slope YC = +152 bps.

 US 01/2007: slope YC = -34 bps.
 Japan 11/2000: slope YC = +170 bps.
 Germany 11/1992: slope YC = -200 bps.
 Empirically, the slope of yield curve is good
predictor of GDP growth rate (i.e.
recession).

11
Yield spread: great recession predictor

12
 2. Liquidity Preference Theory
 Problem with the EH theory:
 yield curve is flat on average while in the data it is upward sloping 90% of
the time.
 Source of problem:
 risk-neutrality assumption in EH theory.
 But short rate next period is not known, it is risky!
 When investors are risk averse, they care not only about the
expected short rate but also about its volatility.
 Investors in long-term bonds want to be compensated
 For “tying up” money for a long time.

 For facing price risk if they need to sell before maturity.

 Conversely, issuers of bonds are willing to pay a higher interest

rate on long-term bonds because
 They can lock in an interest rate for many years

13
 2. Liquidity Preference Theory (continued)

 The associated risk premium is denoted the

liquidity premium (LP)

1  yt (2)  1  yt (1)1  Et yt 1 (1)

1
2  LP
 Based on this theory,
 What is the typical shape of the yield curve?

 Is the forward rate still equal to the expected

future short rate?

14
 2. Liquidity Preference Theory: Examples
LP (+)
YC (+) YC (+)
Yield

Yield
E (+) LP (+)

E (-)

1y Maturity 10y 1y Maturity 10y

Yield

Yield
YC (0) LP(+)
YC (-)
E (-)
E (-)
LP (+)

1y Maturity 10y 1y Maturity 10y

LP is yield spread due to liquidity premium; E is yield spread due to
expected future changes in short rate; YC is the total yield spread.
15
 Liquidity Preference Theory
 Examples on previous slide demonstrate that under the
Liquidity Preference theory:

1. upward sloping yield curve can correspond to either

expected increase or decrease in short-term rates (i.e.,
expected path of short-term rate is ambiguous)
 due to LP, which is always positive

2. but flat or downward sloping yield curve

unambiguously corresponds to an expected decrease
in short-term rates
 since LP is always positive, yield curve slopes down or is flat
ONLY if short-term rates are expected to decrease

16
From BKM

17
18
 3. Segmented Markets Theory

 Also known as preferred habitat theory.

 Some investors trade short-term bonds:
 Short-term interest rates are determined by supply
and demand among these investors.
 Other investors trade long-term bonds:
 Long-term interest rates are determined by supply
and demand among these investors.
 May explain why 30-year rates are typically
lower than 20-year rates.

19
 Concepts to Know

 Expectation Hypothesis
 Liquidity Preference Theory
 Segmented Markets Theory

20