Discuss and evaluate the major theories evaluating the shape of the yield curve. In your answer also discuss the uses of the yield curve in financial markets, why strips are used in the construction of yield curves and why investors would want to invest in zero coupon bonds or strips.
The yield curve is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. The relationship between yield and maturity is referred to as the term structure of interest rates. The Treasury yield curve is the base or benchmark for pricing bonds and setting yields in other areas of the debt market. Moreover, the shape of the yield curve is constructed from U.S Treasury strips which are zero-coupon investments and is used mostly because of the creditworthiness of the treasury market and by extension, has no default or liquidity risk. For better understanding of the positive, inverted or flat shapes of the yield curve, one must first evaluate the major theories which are the pure expectation theory, liquidity theory, market segmentation and lastly, the preferred habitat theory (hybrid) theory. The pure expectations theory assumes that investors’ current expectations of the future and long term Treasury bond rates are dependent on current short term treasury yields. This means that an upward sloping yield curve implies that investors anticipate a future increase in short-term interest rates; and downward sloping yield suggest vice versa. However, this theory disregards the risks inherent when investing in bonds such as price risk and reinvestment risk. Unlike the pure expectations theory, the liquidity theory assumes that due to the uncertainty of the market environment and future interest rates, investors’ demand a premium in the form of additional yield to compensate for price, reinvestment, market and by extension, inflation risk. In other words, it assumes that long-term bonds are more risky and investors’ will demand...
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