180 Part 3 Financial Assets
6-6 USING THE YIELD CURVE TO ESTIMATE FUTURE
INTEREST RATES12
In the last section, we saw that the slope of the yield curve depends primarily on
two factors: (1) expectations about future in" ation and (2) effects of maturity on
bonds’ risk. We also saw how to calculate the yield curve, given in" ation and
maturity-related risks. Note, though, that people can reverse the process: They can
look at the yield curve and use information embedded in it to estimate the mar-
ket’s expectations regarding future in" ation, risk, and short-term interest rates.
For example, suppose a company is in the midst of a 5-year expansion program
and the treasurer knows that she will need to borrow short-term funds a year from
now. She knows the current cost of 1-year money, read from the yield curve, but
she wants to know the cost of 1-year money next year. That information can be
“backed out” by analyzing the current yield curve, as will be discussed.
The estimation process is straightforward provided we (1) focus on Treasury
bonds and (2) assume that Treasury bonds contain no maturity risk premiums.^13
This position has been called the pure expectations theory of the term structure of
interest rates, often simply referred to as the “expectations theory.” The expecta-
tions theory assumes that bond traders establish bond prices and interest rates
strictly on the basis of expectations for future interest rates and that they are indif-
ferent to maturity because they do not view long-term bonds as being riskier than
short-term bonds. If this were true, the maturity risk premium (MRP) would be
zero and long-term interest rates would simply be a weighted average of current
and expected future short-term interest rates.
To illustrate the pure expectations theory, assume that a 1-year Treasury bond
currently yields 5.00% while a 2-year bond yields 5.50%. Investors who want to in-
vest for a 2-year horizon have two primary options:
Option 1: Buy a two-year security and hold it for 2 years.Pure Expectations
Theory
A theory that states that
the shape of the yield
curve depends on
investors’ expectations
about future interest rates.Pure Expectations
Theory
A theory that states that
the shape of the yield
curve depends on
investors’ expectations
about future interest rates.SELF^ TEST How do maturity risk premiums a! ect the yield curve?
If the in" ation rate is expected to increase, would this increase or decrease
the slope of the yield curve?
If the in" ation rate is expected to remain constant at the current level in the
future, would the yield curve slope up, slope down, or be horizontal? Con-
sider all factors that a! ect the yield curve, not just in" ation.
Explain why corporate bonds’ default and liquidity premiums are likely to
increase with their maturity.
Explain why corporate bonds always yield more than Treasury bonds and
why BBB-rated bonds always yield more than AA-rated bonds.(^12) This section is relatively technical, but instructors can omit it without loss of continuity.
(^13) Although most evidence suggests that there is a positive maturity risk premium, some academics and practitioners
contend that this second assumption is reasonable, at least as an approximation. They argue that the market is domi-
nated by large bond traders who buy and sell securities of di" erent maturities each day, that these traders focus only
on short-term returns, and that they are not concerned with maturity risk. According to this view, a bond trader is just
as willing to buy a 20-year bond to pick up a short-term pro# t as he or she is to buy a 3-month security. Proponents of
this view argue that the shape of the Treasury yield curve is therefore determined only by market expectations about
future interest rates. Later we show what happens when we include the e" ects of maturity risk premiums.
corporate bonds have more default and liquidity risk than shorter-term bonds, and
both of these premiums are absent in Treasury bonds.