Week 4 Discussion

The Pure Expectations Theory

The pure expectations theory is one of the theories describing the term structure of interest rates. Under this theory, the rates on long-term securities can be derived as a function of short-term securities. As a result, short-term and long-term securities are good substitutes for each other in investment portfolios.

There are no separate markets for short-term and long-term securities. Investors are interested in the return over a period and not the maturity date of the �nal payment. This implies that the expectation of future short-term rates is a determining factor in long-term rates.

Buying and selling activities exert pressure on the long-term rate, which is an average of the current short-term rate and the expected future short-term rates. If expected future short-term rates are more than the current short-term rates, the yield curve will slope upward. Lower expected short-term rates will cause the curve to slope downward. The yield curve is the plot of the yield versus the maturity of interest bearing securities.

One-year and two-year rates are called spot rates because they are the prevailing rates today. The one-year rate one year from today is called the forward rate.

Interest rate risk: A bondholder wants a return on the risk of holding a bond. The management wants to minimize the cost of funds. The higher the risk, the more the investor wants to be compensated for taking the risk and thus offers a lower price.

Term structure of interest rates: This reveals the relationship between an interest bearing security and its maturity.

Yield curve: This is the plot of the yield versus the maturity of interest bearing securities.

Pure expectations theory: This theory suggests that the shape of the yield curve is based on the expectations of long interest rates being equal to those of a series of short-term interest rates.

Historical or average return: This is the mathematical average of historical returns.

Expected return: The expected return is the weighted average of the expected returns and their respective probabilities.