example 7.6 i want to know why in upward-sloping term structure short-term rates increase more than long-term rates. thx!
If I remember correctly, pure expectation theory only works for short term rates. Therefore, I would assume that nothing can be assumed on the long-term rates and a neutral assumption for the long-term is a flat curve. Does this make sense?
sorry, i cannot follow the “I would assume that nothing can be assumed on the long-term rates and a neutral assumption for the long-term is a flat curve”. Could u mind explaining the details for me? thank u !
I am not sure that I can explain the matter much better than I did. Allow me to try my own, entirely made up, way on how I think about this: In the short term people will have a given set of expectations about the world. Compared to the long term, these expectations are fairly certain. Since they are more certain, the compensation for any lending requires a fairly specific interest rate. However, in the long run, people are faced with a lot more uncertainty. Therefore, after a certain threshold, people are so happy to get at least some certainty (interest) that they stop asking for more. As to why people behave this way is beyond my understanding. Most likely there is some research as to if my explanation is reasonable and what the reasons for such a behavior may be. Sorry if I cannot provide more detail on the matter.
That is a good explanation. Additionally, from a mathmatically standpoint, I think one would argue that the velocity of volatility is greater for short-term rates. Meaning that you would expect ST rates to react more than LT rates (regardless if the term structure is upward or downward sloping).
egal Wrote: ------------------------------------------------------- > I am not sure that I can explain the matter much > better than I did. > Allow me to try my own, entirely made up, way on > how I think about this: In the short term people > will have a given set of expectations about the > world. Compared to the long term, these > expectations are fairly certain. Since they are > more certain, the compensation for any lending > requires a fairly specific interest rate.1 However, > in the long run, people are faced with a lot more > uncertainty. Therefore, after a certain threshold, > people are so happy to get at least some certainty > (interest) that they stop asking for more. > As to why people behave this way is beyond my > understanding. Most likely there is some research > as to if my explanation is reasonable and what the > reasons for such a behavior may be. > Sorry if I cannot provide more detail on the > matter. Hi Egal, you had a gr8 intrepretation, but I have a couple of qns… 1) When people (Long run) have more uncertainity… volatility is more/ risk more - should demand higher yeild to compensate… - I dont think that is going to get the yeild down/constant 2) Pure expc theory says the interest rate is explained by only the investors expected future int rate - Risk is not a consideration for sure, why because that is one the major shortfall of Pure Exp. My understanding : assumption : people expect short term int rate to rise in future… or IOW expected future int rate is high… as suggested by the yield curve… investors will be better off investing in 6 months for a 3% and rolling it over to a 3.3% - Instead of investing for 1 year at a 3%. why it flattens as time goes by… IMHO …is because its a geometric average (1.03 * 1.033) = 3.15% - can someone give an expl around this…