CHAPTER: THE TERM STRUCTURE OF INTEREST RATES

The term structure of interest rates:

There are bonds of different maturities. The relationship between yields on bonds of
different maturities is called the term structure of interest rates.
The term structure of interest rate can be picture as in the figure:
The bond are arranged by maturities on the horizontal axis and their respective
yields are plotted against the vertical axis.

Yield to maturity

B
A
C

C
A
5

B
10 15

20

25

30

Years to maturity

Graph: three Hypothetical yield curves

A curve showing the term structure is called a yield curve. There are different
hypothetical yield curves are depicted in the figure.

3 Hypotheses:
The expectation hypothesis:
Suppose the rate of interest on a one-year default free bond is 2%. The rate of
interest that is expected to prevail on such one-year bonds in the following year is
7%. Then the rate of return on a two-year default free bond sold at present might be
explained as some combination of the rates of return are expected to prevail in year
one and two are 2% and 7% respectively. The view that such relationship existed is
called the expectation hypothesis.

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The current rates are called spot rate and the rates that is expected is called
forward rates. Suppose the current rate on spot for one-year, two-year, and threeyear and so on are S1, S2, S3-----SN. The expected or forward rates are denoted as
r1,r2,r3-----rN. According to the expectation hypothesis:

1+S1=1+r1--------------- (1)
If funds are to be loaned out and bonds are too bought- there are 2 choices:
1. Buy a two-year bond or
2. Buy a series of 2 one-year bond.
(1+S2)2= (1+r1) (1+r2)
1+s2=

(1+r 1)(1+ r 2)

The expectation hypothesis holds that this relationship between observable market
rates of interest on bonds and implied on expected forward rates is approximated in
the bond market.
*Math in the khata.

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Error learning hypothesis:

Devid meiselman produced error learning hypothesis. In this hypothesis participants
in the bond market are held to adjust the yields on bonds by a fixed proportion of
the difference between the actual one-year rate(S1) and one year rate that had
been expected one-year rate becomes r2 in
N

1+SN=

(1+r 1)(1+ r 2)+ .+(1+ rN )

after one year passes.

The entire yield curve is altered as rates are changed to reduce the forecasting
error. Interest rates on bonds with more distant maturities, the long rates, adjust
less rapidly because they are arrange value of money implied one-year rates. Thus
if the one-year rate expected for the current year terms out to be too high. The
entire yield curve shifts downward.

Yield to maturity

A
B
5
10 15
20 25 30
Figure: Error Learning Hypothesis

Years to maturity

In the favor the long rates are corrected least, since a change in the short rate is
only as small part of the arrange on which long rates are held to depend.

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23-01-2014
The Liquidity preference hypothesis:
The liquidity preference hypothesis of the term structure assets that future rates are
combined of expected rates and a liquidity premium. The liquidity premium pays for
capital risk, the risk that the bond will fall in value and a loss will be incurred if it is
sold prior to maturity. In addition, it is asserted that more distant rates have larger
liquidity premium.

Yield to maturity

A
A

10 15

20

25

30

Years to maturity

Graph: The Liquidity preference Hypothesis

Curve AA in the figure is a yield curve that is consistent with expected future rates,
According to the pure expectations hypothesis, Curve AA includes premium in
keeping with the liquidity preference hypothesis.
The liquidity preference hypothesis can be depicted by adding capital risk premium
to each of the implied forward rates. This risk premium would increase in size, the
more distant the rates are in the future.

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Market Segmentation:
One expectation is that each instrument is sold in somewhat unrelated markets.
Market participants are not selling sufficient quantities of treasury notes in another
market to bring the rates in line, after allowances is made for differences in default
risk. There are various hypotheses about this type of phenomenon called market
segmentation hypothesis.

CHAPTER: FINANCIAL MARKET

Financial market:
Financial market is a market where financial assets are traded.
Types of financial market:
There are two types of financial market:
1. Primary market and
2. Secondary market.

1. Primary market:
New financial assets are traded in a specific market which is called primary market.
2. Secondary market:
Financial assets that are resold are traded in a specific types of markets which is
called secondary markets.
There are two types of dealers:
1. Primary dealer:
Firms that specialize in trading new financial assets are called primary dealers.
2. Secondary dealers:

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Firms that specialize in trading re-issued financial assets are called secondary
dealers.

Market participants:
Participants in financial markets can be clarified into four groups according to their
market behavior. They are:
1.
2.
3.
4.

Speculators
Hedters
Arbitrators
Investors.

Speculators:
Speculation occurs when an asset is held for resale at higher price. Many individuals
purchase assets over which they have property rights and plans of resale at a
profitable price. They are called speculator.
Hedters:
Some firms and individuals holds financial assets in order to hedge. Hedging occurs
when two or more assets are held with the expectation that they will have offsetting
price movements because of some non-random relationship between them.

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6.02.2014
1. Commission broker:
Commission brokers are the broker who act on orders from the public relate through
brokers.
2. Specialist:
Specialists buy and sell particular stocks that are assigned to them. They keep a list
of limit and stop orders and take a position by buying and selling and holding the
stocks they are assigned. They attempt to provide contentious trading in a stock at
prices that are close to their concept of normal.
3. Odd lot dealers:
Consolidate and trade stocks for which orders have been received for less than the
standard 100 share multiples.
4. Floor brokers:
Trade for other members on a commission basics.
5. Registered traders:
Trade primarily for themselves.
6. Bond brokers:
Trade bonds in the exchanges bond groom.
7. Stock market option:
A stock market option is financial asset that gives the owner the right to buy or sell
a stock at a particular price before a specified date. The names used in the stock
option market are as follows:
1. An option to sell is called adoption.
2. An option to buy is called a call option.
3. The price at which the owner can buy or sell the stock is called the exercise
price, the striking price or the strike price.

Chapter:
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Money and stock price:

Two views of stock values:

The value of a corporate stock is viewed as the present value of the future profits of
corporation. The stock price (SP) of a share of stock can be inserted for the present
value and expected profits can be used for the income stream. The size of a future
profits is a rough estimate, often with a great deal of uncertainty. The expected
profits in the years 1, 2, 3 and so on are R1, R2, and R3 and so on, there

SP=

R1
1

(1+r )

R2
2

(1+r )

R3
3

(1+r )

Where, r is the rate at which individuals discounts their future.

1st view of stock valuation:

A change in preference towards income today instead of in the future may lower
the price of stock, even though there is no change in expected stream of profits.
The owner of stock receives his or her return from the stock in two ways:
1. Expected dividends and
2. Changes in the price of stock.

This return compared to the price of the stock is a measure of the stock yield or the
rate of return from the stock.
In symbols, the stock yield (SY) is the expected dividend (D) plus any expected gain
in the price of the stock ( SP ) during the year divided by the price of the stock
(SP)

SY =

D+ SP
SP

Math: the dividend is expected to be $11 per year and the stock that
currently sales for $60 is expected to rise in value by $13 during the year.
What is the stock yield?
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ANSWER: khata.

The Efficient market hypothesis:

An explanation of stock prices that has own wide spread support, in the economics
and finance fields is the efficient market hypothesis. Financial markets are send to
be efficient if the prices of the securities traded fully reflect available information
and the transaction costs are negligible.
The requirement that stocks behave as a random walk was found to be an
unnecessary straight requirement for the existence of efficient markets.
Furthermore stocks do not precisely follow a random walk, although day to day
fluctuation one close to be described as a fair game. The fair game explanation of
efficient markets allows general trends in prices but it holds that no one can benefit
from knowing more about stock than its price Given only the present public
knowledge, no trading system or any public information can increase the
expectation of profits.

Chapter: 20
Money and inflation a cash balance approach
Inflation:
An inflation is a sustained rise in the price level. A hyperinflation is defined as an
inflation in which the price level rises 50% or more per month.
The effect of money growth on prices and real income is one part and the other is
the effect of money growth on interest rates. The effect of money growth on interest
rates is further divided into three parts:
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1. The liquidity effect

2. The income effect
3. The price expectation or fisher effect.
Liquidity effect:

The fall in the real rate of interest caused by the increase in supply of real money
balance is called the liquidity effect.
Nominal
interest rates
on bonds

ly f

ly 2
D

ly 2
i=r

i 2=r +
i 1=r 1

A
B

Price Expectation
Liquidity Effect
C Income Effect

lyf

Figure: Liquidity income and expectations effects following an increase in real more
growth.

Explanation:
Suppose that initially the nominal money supply (M) and the price level (P) is
constant. The initial position where the demand and supply of real money balances
are in agreement is at point B in the figure. If the interest rate increase the supply of
real money balance relative to the demand for real money balance pushing down
the interest rates. The fall in the real rate of interest caused by the increase in
supply of real money balance is called the liquidity effect. In the figure the interest
rates moves from r to r1. The intersection of the demand and supply for real money
balances moves from B down to C, as M/P grows.
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The result is a rise in real income, created by the new demand for goods and
services and a much slower and more delayed rise in prices. The rise in real income
causes the whole demand for real money balances curve to shift out to the right,
through point D. the resulting rise in interest rates is called the income effect.

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