20-Term Structure Page 613 Wednesday, February 4, 2004 1:33 PM
Term Structure Modeling and Valuation of Bonds and Bond Options 613EXHIBIT 20.3 (Continued)Yields (%)
2-Yr 5-Yr 10-Yr 30-YrUnited
States9/5/03 1.71 3.25 4.35 5.21
9/12/03 1.62 3.15 4.26 5.17
W-o-W Chg (bp) –9 –10 –9 –4
Germany 9/5/03 2.60 3.54 4.30 4.98
9/12/03 2.44 3.36 4.17 4.90
W-o-w Chg (bp) –16 –18 –13 –8
United
Kingdom9/5/03 4.16 4.46 4.69 4.77
9/12/03 4.05 4.36 4.57 4.69
W-o-w Chg (bp) –11 –10 –12 –8
Japan 9/5/03 0.19 0.74 1.44 1.79
9/12/03 0.20 0.73 1.54 1.98
W-o-w Chg (bp) 1 –1 10 19Source: Lehman Brothers, “Global Relative Value,” Fixed Income Research, Sep-
tember 8, 2003, p. 13.will lie above the spot rate curve. The reverse is true if the yield curve is
downward sloping. If the yield curve is flat, all three curves are flat.
Two major economic theories have evolved to account for these
observed shapes of the yield curve: expectations theories and market
segmentation theory. We describe these theories below. However, these
are qualitative theories that tend to explain general features of market
behavior. The quantitative determination of interest rates is a major
problem of macroeconomics; it is made particularly challenging by the
fact that interest rates are influenced by both market forces and by the
decisions of central banks. In principle, General Equilibrium Theories
(GET) can determine interest rates endogenously. However, GET remain
an abstract tool; it is virtually impossible to apply them to practical
forecasting. In practice, the forecast of interest rates for bond and bond
option valuation is made using econometric models. Later in this chap-
ter we will take a look at the structure and form of econometric models
used to forecast interest rates, or represent their stochastic evolution.Expectations Theories
There are several forms of the expectations theory: pure expectations
theory, liquidity theory, and preferred habitat theory. Expectations theo-
ries share a hypothesis about the behavior of short-term forward rates