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Yield Curve Analysis - Chapter 4 - YouTube
Channel: DNA Training & Consulting
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this final chapter before the quiz
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chapter four analyzes the shapes a yield
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curve can take and examines the
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classical explanations given for why a
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curve has a particular shape at a given
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time in general three theories are used
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often in combination to explain the
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shape of the yield curve for the rest of
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this chapter the curve generally
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referred to will be the zero-coupon
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curve
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we named them first and analyzed them
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afterwards individually these three
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theories are the expectations theory the
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liquidity theory sometimes called the
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term premium theory and the preferred
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habitat theory disputes continued to
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this day
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regarding the relative accuracy of these
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alternative theories and the extent to
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which any of them correctly explains the
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shape of the curve between any two
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points we can only summarize in the
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briefest of ways the principal arguments
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for and against each theory and point
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you to the thousands of pages of
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academic and professional research on
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this topic if you are hungry for more we
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turn first to the expectations theory
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this theory states in essence that the
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shape of the curve reflects market
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expectations regarding future interest
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rates and specifically that an upward
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sloping curve reflects expectations of
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rising rates a flat curve reflects
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neutral expectations and an inverted
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curve reflects expectations of falling
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rates
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certainly in cases of a steep upward
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sloping curve or one that is
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significantly inverted particularly at
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the short end research confirms the
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accuracy of this theory to some degree
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simple polling of economists at those
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times regarding their interest rate
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forecasts which are then compared to the
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forward rates implied by the curve show
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some reasonable but not perfect
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correlation between these two items
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sluttish curves are also generally
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consistent with neutral expectations
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regarding future short term interest
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rates but again no perfect correlation
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is observed nor should it be expected
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with something as complex as the yield
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curve interestingly on the few occasions
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when the curve has been extremely steep
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at the short end rates have in fact
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usually proceeded to fall instead of
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rising significantly as implied by the
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level of the forward but instances of
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very steep curves are really too rare to
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generalize much from observed precedents
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the liquidity or term premium theory is
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one we touched upon earlier and states
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that the longer the tenor of the
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instrument the greater should be its
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expected return all other things being
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equal this results from investors
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preference for short thinner assets and
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specifically ones with low price
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volatility and/or which can be turned
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into cash more easily than others either
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by selling them into the secondary
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market at close to their par value or in
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a worst-case scenario
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by holding them until maturity thus
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under this theory even when interest
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rate expectations are neutral we should
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expect the curve to be upward sloping to
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some degree otherwise no incentive would
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exist for extending maturity and thus
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assuming greater price risk and lower
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asset liquidity the fact is that over
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the last 50 years say us short-term
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interest rates have moved within a wide
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range starting in the late 50s at lowish
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levels then rising pretty steadily
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throughout the 60s and 70s and then
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peaking in the early 80s above 20%
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before beginning a more or less
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continuous decline into the new
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millennium and hitting bottom of course
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in recent years
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we might conclude from this pattern that
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on average expectations have been
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cumulatively neutral despite of course
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extended periods in which rates were
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expected to be rising or falling
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steadily and yet the curve has been
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upward sloping some 90% of the time
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during this half century suggesting some
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evidence of a term premium in bond
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yields ie
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some evidence of a higher yield on
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account solely of the extension of
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maturity please note that the two
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factors we have analyzed so far can
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sometimes neutralize one another to some
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degree in a market in which short-term
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rates are generally let's say expect it
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to fall and yet preference for low
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duration assets is significant the first
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factor would cause the curve to invert
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as we have learned while the second
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factor would cause the curve to slope
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upward and if these two factors are a
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roughly equal impact the curve of course
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could end up being pretty flat the third
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and final theory the preferred habitat
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theory
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correctly points out that certain
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investors especially regulated
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institutions are often attracted to one
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particular point or range within the
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curve and repelled by another point or
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another range for reasons different from
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the quest for yield including regulatory
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factors tax factors accounting factors
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legal factors among others suppose for
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example that pension funds are severely
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penalized by the law if they find
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themselves underfunded which means
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roughly that the market value of their
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assets is materially less than the
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present value of their projected
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liabilities which liabilities they tend
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to view as very long-term in nature
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particularly in the case of those
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pension funds whose customers are
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predominantly young and healthy men and
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women
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a fall in long-term rates therefore
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pushes the present value of these
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liabilities up quite measurably given
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their very long duration and therefore
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an excellent hedge for this problem is
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obviously for the pension fund to
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purchase very long dated bonds even when
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the yields on these are substantially
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lower than they are on medium-term bonds
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of comparable credit quality while
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economically the medium-term instruments
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may offer the higher expected return
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over the long term the risk of reducing
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asset duration and finding oneself
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underfunded following a steep decline in
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rates is often too great to be
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contemplated this pushes the pension
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fund out as far as possible along the
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curve causing the long end to invert
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substantially in some countries in a
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market in which frictions of this kind
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are non-existent this would be unlikely
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to happen but virtually all markets even
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in the most capitalistic economies do
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impose some significant frictions on
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their pension funds on their banks and
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on their insurance companies among
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others an example from the opposite end
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of the curve involves money market funds
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central banks and even corporate
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Treasuries who due to pressure of a
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political or regulatory nature or
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sometimes due to the preference of the
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credit rating agencies often tend to
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keep their cash invested in Treasury
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bills of the very shortest maturity even
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though a slight lengthening of maturity
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could result in a yield pickup of some
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25 or 50 basis points annually
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or more in turn this causes the shortest
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end of the curve to slope upward
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significantly even when interest rate
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expectations are neutral or even are
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inclined towards lower rates this
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completes chapter 4
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