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U-3 and U-6 Unemployment Rates
Civilian Labor Pool = 155 million
U-3 = 7.2% of civilian labor pool (7.9 last year) Those without jobs, who are available to work and who have actively sought work in the prior four weeks.
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U-6 = 13.6% (14.7 last year) Includes “marginally attached workers” (1) neither working nor looking for work, but say they want
a job, and (2) want to work full-time but are working part-time
because that is best they can find.
11/7
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Four Theories
Four prominent theories used to explain the shape of the yield curve.
1. Expectation theory
2. Liquidity premium theory
3. Market segmentation theory
4. Preferred habitat theory
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(1) Expectation Theory Says…
• Shape of yield curve determined by expectations about future rates. Changes in expectations cause changes in the yield curve.
• Assumes investors are indifferent between a long-term security and a series of short-term securities.
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Term Structure Formula
0 1 1 1 2 1 1 1 0
0 1 1 1 2 1 1 1 0
1 1 1 1 1
1 1 1 1 1
n
n n
nn n
R f f f R
R f f f R
• Long-term interest rates are the geometric average of current and future period rates.
where: R observed market rate f forward rate n maturity of bond prescript time at which period starts (0 is “now”) subscript length of period
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Implied 1-Year Forward Rate Formula
01 1 1
0 1
11
1
n
nn n
n
Rf
R
Example of how to apply:
1. Want implied yield of a 1-year security that starts 6 years from now.
2. Look up yields on 6-year security and 7-year security.
3. Use formula above with n = 7.
Implied forward rate for the n-th period coming up
Example 3: Calculating Forward Rates
Assume following Treasury security quotes:yrs to
maturity YTM
1 2014 7-Nov 0.8953
2 2015 7-Nov 1.3725
3 2016 7-Nov 1.8770
4 2017 7-Nov 2.3172
5 2018 7-Nov 2.6626
Find the 1-year implied forward rates during nth period (where n = 2,3,4,5)
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Example 4: Using Formula
Using
find the 1-year implied forward rate during 3rd year
1-year Treasury bill 1.9%2-year Treasury note 2.4%3-year Treasury note 2.7%
01 1 1
0 1
11
1
n
nn n
n
Rf
R
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(2) Liquidity Premium Theory Says…
• Long-term securities have greater price risk, and generally less marketability.
• Liquidity premiums contribute to an upward tendency of a yield curve.
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(3) Market Segmentation Theory Says…
• Market participants may have strong preferences for particular maturities, and buy and sell securities consistent with these preferences.
• Can theoretically lead to discontinuities in yield curve.
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(4) Preferred Habitat Theory Says…
• Preferred Habitat Theory (an extension of Market Segmentation Theory) allows market participants to trade outside of their preferred maturities if adequately compensated.
• Preferred Habitat Theory allows for humps in the yield curve.
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Operation Twist
“Operation Twist” is the nickname for the Fed’s 2011-12 initiative of buying longer-term Treasuries and simultaneously selling some of the shorter-dated issues it already held in order to bring down long-term interest rates.
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Why Not Only Short-Term Debt?
Q. Why not finance long-term needs by continually refinancing short-term debt?
A. Firms do more of this than they should. There will always be periods when can not roll over. Then need a bailout (like Fed had to do in 2008-09).
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Which Theory is Right?
• Each has its point.
• Day-to-day changes in the term structure are most consistent with the Preferred Habitat Theory.
• Many economists also feel that expectations and liquidity premiums are important in determining the yield curve.
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Default Risk
• Investors require a default risk premium.
• DRP = i – irf > 0
• Investors satisfied when feel that DRP offsets expected default loss.
• Default risk premiums tend to increase in periods of recession (when people scared) and decrease in periods of economic expansion (when people overconfident).
• “flight-to-quality”• Bond ratings are only for default risk.
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NRSROs• Nationally Recognized Statistical Rating Organizations
• NRSROs are credit-rating agencies authorized by the SEC and banking regulators. Currently 10 (best known Moody’s, Standard & Poor’s, Fitch).
• BBB- (Baa3) and above are investment-grade, below are speculative-grade or “junk.”
• Issuers pay to have their bonds rated. Banks, insurance companies, pension funds, many mutual funds can only hold investment-grade bonds.
• As conditions change, rating agencies change their ratings. Bad when an issue’s rating drops below cutoff.
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Default Rates
AAA 0.52%AA 1.31A 2.32BBB 6.64BB 19.52B 35.76CCC 54.38
Bond default history when initially rated:
History with recent mortgage securities entirely different.
The agencies also rate commercial paper (discussed elsewhere).
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Call Options
• A call option permits the issuer (borrower) to call (refund) the obligation before maturity.
• Borrowers will “call” if interest rates decline.
• Investors in callable securities bear the risk of losing their high-yielding security.
• investors demand a call interest premium.
• CIP = ic – inc > 0
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Put Options
• A put option permits the investor (lender) to terminate the contract at a designated price before maturity.
• Investors are likely to “put” their bond back to the borrower during periods of high interest rates.
• The difference in interest rates between putable and nonputable contracts is called the put interest discount.
• PID = ip – inp < 0
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