Bonds, Bond Prices, Interest Rates, and the Risk

and Term Structure of Interest Rates

ECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Fall 2017

1 / 68
Readings

I Text:
I Mishkin Ch. 4, Mishkin Ch. 5 pg. 85-100, Mishkin Ch. 6
I Other:
I Poole (2005): “Understanding the Term Structure of Interest
Rates”
I Bernanke (2016), “What Tools Does the Fed Have Left? Part
2: Targeting Longer-Term Interest Rates”

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Bonds

I We will generically refer to a “bond” as a debt instrument

where a borrower promises to pay the holder of the bond (the
lender) interest plus principal at some known date
I There are many different types of bonds. Differ according to:
I Details of how bond is paid off
I Time to maturity
I Default risk
I The yield to maturity is a measure of the interest rate on the
bond, although the interest rate is often not explicitly laid
out. Will use terms interest rate and yield interchangeably
I Want to understand how interest rates are determined and
how and why they vary across different characteristics of
bonds

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Present Value
I Present discounted value (PDV): a dollar in the future is
worth less than a dollar in the present
I You “discount” future payouts relative to the present because
you could put money “in the bank” in the present and earn
interest
I For a future cash flow (CF ), how many dollars would be
equivalent to you today:
CFt +n
PVt =
(1 + it )(1 + it +1 )(1 + it +2 ) · · · × (1 + it +n−1 )
I Here t is the “present,” t + n is the future (n periods away),
and it , it +1 , . . . are the one period interest rates between
periods
I If it = it +1 = · · · = it +n−1 = i, then formula reduces to:
CFt +n
PVt =
(1 + i )n
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Present Value: Example I

I Suppose you are promised $10 in period t + 1

I You could put $1 in bank in period t and earn it = 0.05 in
interest between t and t + 1
I How many dollars would you need in the present to have $10
in the future?

(1 + it )PVt = CFt +1
CFt +1
PVt =
1 + it
10
= = 9.5238
1.05

5 / 68
Present Value: Example II
I Suppose you are promised $10 in period t + 3
I You could put $1 in bank in period t and earn it = 0.05 in
interest between t and t + 1
I You expect to be able to earn interest of it +1 = 0.07 between
t + 1 and t + 2 and it +2 = 0.03 between t + 2 and t + 3
I If you put $1 in bank in period t and kept it there
(re-investing any interest income), you would have
(1 + it )(1 + it +1 )(1 + it +2 ) dollars in t + 3. Hence, the
present value of $10 three periods from now is:

PVt (1 + it )(1 + it +1 )(1 + it +2 ) = CFt +3

CFt +3
PVt =
(1 + it )(1 + it +1 )(1 + it +2 )
10
= = 8.6415
(1.05)(1.07)(1.03)

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Present Value and the Price of an Asset

I A financial asset is something which entitles the holder to

periodic payments (cash flows)
I The classical theory of asset prices is that the price of an asset
is equal to the present discounted value of all future cash flows
I A bond is an asset: it entitles you to periodic cash flows. A
stock is another kind of financial asset
I Price is just the present discounted value of cash flows
I The yield or interest rate on an asset is the interest rate you
use to discount those future cash flows

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Different Types of Bonds
I The following are different types of bonds/debt instruments
depending on the nature of how they are paid back:
1. Simple loan: you borrow X dollars and agree to pay back
(1 + i )X dollars at some specified date (interest plus principal)
(e.g. commercial loan)
2. Fixed payment loan: you borrow X dollars and agree to pay
back the same amount each period (e.g. month) for a specified
period of time. “Full amortization” (e.g. fixed rate mortgage)
3. Coupon bond: you borrow X dollars and agree to pay back
fixed coupon payments, C , each period (e.g. year) for a
specified period of time (e.g. 10 years), at which time you pay
off the “face value” of the bond (e.g. Treasury Bond)
4. Discount bond: you borrow X dollars and agree to pay back Y
dollars after a specified period of time with no payments in the
intervening periods. Typically, Y > X , so the bond sells “at a
discount” (e.g. Treasury Bill)
I Interest rate is not explicit for coupon or discount bonds

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Yield to Maturity

I The yield to maturity (YTM) is the (fixed) interest rate that

equates the PDV of cash flows with the price of the bond in
the present
I This measures the return (expressed at an annualized rate)
that would be earned on holding a bond if it is held until
maturity
I The YTM does not necessarily correspond to the return if the
bond is not held until maturity (i.e. if you sell a bond before
its maturity date)
I The YTM is another way of conveying the price of a bond,
taking future cash flows as given

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YTM on a Simple Loan
I The YTM on a simple loan is just the contractual interest rate
I For a one period loan, the YTM is the same thing as the
return
I Let P be the price of the loan, CF the payout after one year,
and i the interest rate. Then:
CF
P=
1+i
I Or:
CF
1+i =
P
I Or:
CF − P
i=
P
CF −P
I Where P is the return (or rate of return) on the loan

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Price and Yield on a Simple Loan
1 Year Maturity, F = 1000, Simple Loan
0.25

0.2

0.15
Y TM

0.1

0.05

0
800 820 840 860 880 900 920 940 960 980 1000
P

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YTM on a Discount Bond

I The YTM on a discount bond is similar to a simple loan, just

with different maturities
I In particular, for a face value of F , maturity of n, and price of
P, the YTM satisfies:
F
P=
(1 + i )n
I Or:   n1
F
1+i =
P

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Price and Yield on a Discount Bond
10 Year Maturity, F = 1000, Discount Bond
0.08

0.07

0.06

0.05
Y TM

0.04

0.03

0.02

0.01

0
500 550 600 650 700 750 800 850 900 950 1000
P

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YTM on a Coupon Bond
I Suppose a bond has a face value of $100 and a maturity of
three years
I It pays coupon payments of $10 in years t + 1, t + 2, and
t + 3 (the coupon rate in this example is 10 percent)
I The face value is paid off after period t + 3
I The period t price of the bond is $100
I The YTM solves:
10 10 10 100
100 = + + +
1+i (1 + i )2 (1 + i )3 (1 + i )3
I Which works out to i = 0.1
I More generally, for an n period maturity:
n
C FV
P= ∑ (1 + i )j +
(1 + i )n
j =1

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Price and Yield on a Coupon Bond
30 Year Maturity, F = 1000, Coupon Rate = 10 Percent
0.13

0.125

0.12

0.115

0.11
Y TM

0.105

0.1

0.095

0.09

0.085

0.08
800 850 900 950 1000 1050 1100 1150 1200
P

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Perpetuities

I Perpetuities (also called “consols”) are like coupon bonds,

except they have no maturity date
I Here, the relationship between price, yield, and coupon
payments works out cleanly and is given by:
C
i=
P
I For a coupon bond with a sufficiently long maturity, this is a
reasonable approximation to the bond’s YTM (because the
PDV of the face value after many years is close to zero)
I This expression is also sometimes called the current yield as
an approximation to the YTM on a coupon bond

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Price and Yield on a Perpetuity
Perpetuity, C = 100
0.1

0.095

0.09

0.085

0.08
Y TM

0.075

0.07

0.065

0.06

0.055

0.05
1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000
P

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Observations

I Several observations are noteworthy from the previous slides:

1. The bond price and yield are negatively related. This is true
for all types of bonds. Bond prices and interest rates move in
opposite directions
2. For discount bonds, we would not expect price to be greater
than face value – this would imply a negative yield
3. For a coupon bond, when the bond is priced at face value, the
yield to maturity equals the coupon rate
4. For a coupon bond, when the bond is priced less than face
value, the YTM is greater than the coupon rate (and
vice-versa)

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Yields (Interest Rates) and Returns
I Returns and yields (interest rates) are in general not the same
thing
I Rate of return: cash flow plus new security price, divided by
current price
I Useful way to think about it (terminology here is related to
equities): “dividend rate plus capital gain,” where capital gain
is the change in the security’s price
I The return on a coupon bond held from t to t + 1 is:
C + Pt +1 − Pt
R=
Pt
I Or:
C Pt + 1 − Pt
R= +
Pt P
|{z} | {zt }
Current Yield Capital Gain
I Return will differ from current yield (approximation to YTM)
if bond prices fluctuates in unexpected ways
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Discount Bond
I Suppose that you hold a discount bond with face value $1000,
a maturity of 30 years, and a current yield to maturity of 10
percent
1000
I The current price of this bond is = 57.31.
1.130
I Suppose that interest rates stay the same after a year. Then
1000
the bond has a price of 1.1 29 = 63.04

I Since there is no coupon payment, your one year holding

period return (holding period refers to length of time you hold
the security) is just the capital gain:

Pt + 1 − Pt 63.04 − 57.31
R= = = 0.10
Pt 57.31
I If interest rates do not change, then the return and the yield
to maturity are the same thing

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Interest Rate Risk

I Continue with the same setup

I But now suppose that interest rates go up to 15 percent in
period t + 1 and are expected to remain there
I Then the price of the bond in period t + 1 will be:
1000
1.1529
= 17.37
I Your return is then:
Pt + 1 − Pt 17.37 − 57.31
R= = = −0.69
Pt 57.31
I On a discount bond, an increase in interest rates exposes you
to large capital loss

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Return and Time to Maturity, Coupon Bond
Interest Rate Increase from 10 to 15 Percent, 10 Percent Coupon Rate, F = 1000
0.1

0.05

-0.05
R

-0.1

-0.15

-0.2

-0.25
0 5 10 15 20 25 30
Time to Maturity

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Observations
I Return and initial YTM are equal if the holding period is the
same as time to maturity (1 period). The capital gain is
simply the face value (which is fixed) minus the initial price
I Increase in interest rates results in returns being less than
initial yield
I Reverse is true
I Return is more affected by interest rate change the longer is
the time to maturity
I If you hold the bond until maturity, your return is locked in at
initial YTM
I Concept of return is relevant even if you do not sell the bond
and realize the capital loss. There is an opportunity cost – if
interest rates rise, had you not locked yourself in on a long
maturity bond you could have purchased a bond in the future
with a higher yield
I Longer maturity bonds are therefore riskier than short
maturity bonds
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Determinants of Bond Prices (and interest rates)

I What determines bond prices and interest rates?

I Supply and demand!
I Though there are many different kinds of bonds and many
different kinds of issuers of bonds, think about a world in
which there is just one type of bond (and just one type of
interest rate)
I For simplicity, think of this as a discount bound
I Remember: bond prices and interest rates move opposite one
another

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Portfolio Choice

I Our theory of demand of a bond (or any asset) is that

demand is based on the following factors:
1. Wealth: assets are normal goods, so the more wealth, the
more you want to hold at every price
2. Expected returns: you hold assets to earn returns. The higher
the expected return, the more of it you demand
3. Risk: assume agents are risk averse. Holding expected return
constant, you would prefer a less risky return. The more risky
an asset is, the less of it you demand
4. Liquidity: refers to the ease with which you can sell an asset.
The more liquid it is, the more attractive it is to hold (it’s
easier to sell if you need to raise cash in a pinch)

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Demand for Bonds

I How does the demand for bonds vary with the price of bonds?
I As the price goes down, the interest rate goes up
I Therefore, holding everything else fixed, the expected return
on holding a bond goes up as the price falls
I Therefore, demand slopes down
I Demand will shift (change in quantity demanded for a given
price) with changes in other factors

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Bond Demand
𝑃

Shifts right if:

(i) Wealth goes up
(ii) Expected return goes up
(iii) Riskiness goes down
(iv) Liquidity goes up

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Supply of Bonds

I Issuers of bonds are borrowers. You are issuing a bond to raise

funds in the present to be paid back in the future
I Recall that bond prices move opposite interest rates
I As the bond price increases, the yield decreases
I Therefore, at a higher bond price, the cost of borrowing is
lower
I So there will be more supply of bonds at a higher price –
supply slopes up
I Changes in other factors, holding price fixed, will cause the
supply curve to shift

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Bond Supply
𝑆
𝑃

Shifts right if:

(i) Expected profitability
goes up
(ii) Expected inflation
goes up
(iii) Government deficit
goes up

29 / 68
Bond Market Equilibrium
𝑆𝑆
𝑃𝑃

𝑃𝑃∗

𝐷𝐷

𝑄𝑄
𝑄𝑄 ∗

30 / 68
Equilibrium
I The intersection of supply and demand determines the
equilibrium price and quantity of bonds
I By determining price, the equilibrium effectively determines
the interest rate, which is inversely related to price
I An alternative way to think about equilibrium is the market
for loanable funds
I The loanable funds diagram puts the interest rate (rather than
bond price) on the vertical axis, and essentially swaps who
demands and who supplies:
I In the previous setup, savers demand bonds whereas borrowers
supply bonds
I In the loanable funds setup, savers supply funds whereas
borrowers demand funds
I We call the supply curve the supply of savings, and the
demand curve the demand for investment. In equilibrium, we
must have S = I

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Loanable Funds Diagram
𝑆𝑆
𝑖𝑖

𝑖𝑖 ∗

𝐼𝐼

𝑆𝑆, 𝐼𝐼
𝑆𝑆 ∗ = 𝐼𝐼 ∗

32 / 68
An Increase in Risk
𝑆𝑆
𝑃𝑃

An increase in perceived risk reduces

demand for bonds, resulting in lower
bond prices and higher interest rates

𝑃𝑃0∗

𝑃𝑃1∗

𝐷𝐷
𝐷𝐷′

𝑄𝑄
𝑄𝑄1∗ 𝑄𝑄0∗

33 / 68
An Increase in Liquidity
𝑆𝑆
𝑃𝑃

An increase in liquidity increases

𝑃𝑃1∗ demand, raises bond prices, and
therefore lowers interest rates

𝑃𝑃0∗

𝐷𝐷′

𝐷𝐷

𝑄𝑄
𝑄𝑄0∗ 𝑄𝑄1∗

34 / 68
An Increase in Expected Future Interest Rates
𝑆𝑆
𝑃𝑃

An increase in expected future

interest rates lowers expected bond
returns. This shifts the demand curve
in, resulting in a lower price and
higher yield
𝑃𝑃0∗

𝑃𝑃1∗

𝐷𝐷
𝐷𝐷′

𝑄𝑄
𝑄𝑄1∗ 𝑄𝑄0∗

35 / 68
An Increase in Government Budget Deficit
𝑆𝑆
𝑃𝑃
𝑆𝑆′

An increase in government budget

deficits causes the supply of bonds to
shift to the right, resulting in lower
bond prices and higher interest rates
𝑃𝑃0∗

𝑃𝑃1∗

𝐷𝐷

𝑄𝑄
𝑄𝑄0∗ 𝑄𝑄1∗

36 / 68
Different Bond Characteristics

I Bonds with the same cash flow details (e.g. discount bonds
vs. coupon bonds vs. perpetuities) nevertheless often have
very different yields
I Why is this?
I Aside from details about cash flows, bonds differ principally
on two dimensions:
1. Default risk
2. Time to maturity

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Default Risk
I Default occurs when the borrower decides to not make good
on a promise to pay back all or some of his/her outstanding
debts
I We think of federal government bonds as being (essentially)
default-free: since government can always “print” money,
should not explicitly default (though monetization of debt is
effectively form of default)
I Corporate (and state and local government) bonds do have
some default risk
I Rating agencies: Aaa is highest rated, then Bs, then Cs
measure credit risk of lenders
I Risk premium: difference (i.e. spread) between yield on
relatively more risky debt (e.g. Aaa corporate debt) and less
risk debt (e.g. government debt), assuming same time to
maturity
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Yields on Different Bonds

39 / 68
Observations

I We see more or less exactly the pattern we would expect from

our demand/supply analysis – risker bonds have higher yields
I Obvious exception: municipal bonds
I Why? Interest income on these bonds is exempt from federal
taxes, which makes their expected returns higher, and
therefore drives up price (and drives down yield)
I Important: interesting time variation in spreads (see next
couple of slides)

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 Moody's Seasoned Aaa Corporate Bond Yield Relative to Yield on 10-Year Treasury Constant Maturity©

3.5

3.0

2.5

2.0
Percent

1.5

1.0

0.5

0.0

-0.5
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: Federal Reserve Bank of St. Louis

fred.stlouisfed.org myf.red/g/dU3z

41 / 68
 Moody's Seasoned Baa Corporate Bond Yield Relative to Yield on 10-Year Treasury Constant Maturity©

5
Percent

1
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: Federal Reserve Bank of St. Louis

fred.stlouisfed.org myf.red/g/dTre

42 / 68
Countercyclical Default Risk

I It stands to reason that default risk ought to be high when

economy is in recession
I When default risk is high, we might expect a “flight to
safety”: reduces demand for risky bonds and increases
demand for riskless bonds, which moves credit spread up
I This is consistent with what we see in the previous slides:
credit spreads tend to rise during recessions

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Flight to Safety
Corporate Bonds Government Bonds
𝑃𝑃 𝑃𝑃
𝑆𝑆 𝑆𝑆

𝑃𝑃1

𝑃𝑃0 𝑃𝑃0

𝑃𝑃1

𝐷𝐷′

𝐷𝐷 𝐷𝐷
𝐷𝐷′
𝑄𝑄 𝑄𝑄0 𝑄𝑄1 𝑄𝑄
𝑄𝑄1 𝑄𝑄0

44 / 68
Yields During Great Recession

Yields and the Great Recession

10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00

Baa Aaa 10 Yr Treasury

45 / 68
Term Structure of Interest Rates

I Bonds with otherwise identical cash flows and risk

characteristics can have different times to maturity (or just
maturities, for short)
I How do yields vary with time to maturity for a bond with
otherwise identical characteristics?
I A plot of yields on bonds against the time to maturity is
known as a yield curve

46 / 68
47 / 68
 6

4
Yield to Maturity

2017
2014
3
2011
2009
2
2008

1 2007

0
1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
Time to Maturity

48 / 68
Observations

I The following observations can be made from previous two

pictures
1. Yields on bonds of different maturities tend to move together
2. Yield curves are upward-sloping most of the time
I The slope of the yield curve is often predictive of recession.
Flat or downward-sloping (“inverted”) yield curves often
precede recessions
3. When short term interest rates are low, yield curves are more
likely to be upward-sloping

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Yield Curves Prior to Recent Recessions
9
8
7
Yield to Maturity

6
5
2007
4
2000
3
1990
2
1
0
3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30yr
Time to Maturity

50 / 68
Theories of the Yield Curve

I We would like to understand the term structure of interest

rates:
1. Expectations hypothesis
2. Segmented markets
3. Liquidity premium theory
I The liquidity premium theory essentially combines (1) and (2)

51 / 68
Expectations Hypothesis
I Expectations hypothesis: the yield on a long maturity bond is the
average of the expected yields on shorter maturity bonds
I For example, suppose you consider 1 and 2 year bonds
I The yield on a 1 year bond is 4 percent; you expect the yield on a 1
year bond one year from now to be 6 percent
I Then the yield on a two year bond ought to be 5 percent
(0.5 × (4 + 6) = 5)
I Why? If you buy a two 1 year bonds in succession, your yield over
the two year period is (approximately, ignoring compounding) 10
percent – (1 + 0.04) × (1 + 0.06) − 1 = 0.1024 ≈ 0.10
I If the 2 and 1 year bonds are perfect substitutes, the yield on the
two year bond has to be the same: (1 + i )2 = 0.1 ⇒ i ≈ 0.05
I Demand and supply: if you expect future short yields to rise, this
lowers expected profitability of long term bonds in the present,
reducing demand, driving down price, and driving up yield: current
long term yield tells you something about expected future short
term yields
52 / 68
Simple Theory Behind the Expectations Hypothesis
I A household lives for three periods: t, t + 1, and t + 2.
Consumes (C ) and earns income (Y ). Lifetime utility:

U = ln Ct + β ln Ct +1 + β2 ln Ct +2

I In period t, can save in either a one period bond, B1,t , or a

two period bond, B2,t . Normalize prices in t to 1, with yields
(interest rates) of i1,t and i2,t (could equivalently make these
discount bonds with future prices of 1 and current prices less
than 1 with yields implicit rather than explicit)
I In period t + 1, can save in a one period discount bond,
B1,t +1 , with yield of i1,t +1 . Sequence of budget constraints:

Ct + B1,t + B2,t = Yt
Ct +1 + B1,t +1 = Yt +1 + (1 + i1,t )B1,t
Ct +2 = Yt +2 + (1 + i1,t +1 )B1,t +1 + (1 + i2,t )2 B2,t

53 / 68
Optimality Conditions
I The optimality conditions can be written as a sequence of
Euler equations:
1 1
=β (1 + i1,t )
Ct Ct +1
1 1
=β (1 + i1,t +1 )
Ct + 1 Ct +2
1 1
= β2 (1 + i2,t )2
Ct Ct + 2

I If you combine these, you get:

(1 + i1,t )(1 + i1,t +1 ) = (1 + i2,t )2
I Which is approximately:
1
i2,t ≈ [i1,t + i1,t +1 ]
2
54 / 68
More Generally
I For a bond with a maturity of n periods, the expectations
theory tells us:
it + ite+1 + · · · + ite+n−1
in,t =
n
I Yields after period t have e superscripts to denote that they
are expectations
I Observing in,t and it in period t, this relationship can be used
to infer market expectations of future short term interest rates
(“forward rates”). In particular:

ite+1 = 2i2,t − it
ite+2 = 3i3,t − 2i2,t
..
.
ite+h = (h + 1)ih+1,t − hih,t

55 / 68
Implied 1 Year Ahead Forward Rate

10

8 Forward Rate 1 Yr Ago

Realized 1 Yr Rate
7

0
1991 1994 1997 2000 2003 2006 2009 2012 2015

56 / 68
Implied 2 Year Ahead Forward Rate

10

8
Forward Rate 2 Yrs Ago
7

6
Realized 1 Yr Rate
5

0
1992 1995 1998 2001 2004 2007 2010 2013 2016

57 / 68
Evaluating the Expectations Hypothesis

I Expectations hypothesis can help make sense of several facts:

1. Long and short term rates tend to move together. If current
short term rates are low and people expect them to stay low
for a while (interest rates are quite persistent), then long term
yields will also be low
2. Why a flattening/inversion of yield curve can predict
recessions. If people expect economy to go into recession, they
will expect the Fed to lower short term interest rates in the
future. If short term interest rates are expected to fall, then
long term rates will fall relative to current short term rates,
and the yield curve will flatten.
I Where the expectations hypothesis fails: why are yield curves
almost always upward-sloping? If interest rates are
mean-reverting, then the average yield curve ought to be flat,
not upward-sloping

58 / 68
Segmented Markets Hypothesis
I The Expectations Hypothesis assumes that bonds of different
maturities are perfect substitutes, which forces expected
returns to be equal across bonds of differing maturities
I Segmented Markets is the polar extreme: bonds of different
maturities aren’t substitutes at all
I If this is the case, there is no reason for returns to be equalized
I Furthermore, since longer maturity bonds are subject to more
interest rate risk, there will in general be more demand for
short term bonds than long term bonds
I This means that the price of short term bonds will be high
relative to long term bonds, meaning that long term bonds
will have higher yields
I Hence, segmented markets can explain why yield curves slope
up most of the time

59 / 68
Liquidity Premium Theory
I Segmented markets hypothesis cannot explain why interest
rates of different maturities tend to move together, or account
for why you can predict future short term rates from long
term yields
I Liquidity premium theory: essentially combines expectations
hypothesis with market segmentation
I Bonds of different maturities are substitutes, but not perfect
substitutes: savers demand higher yields on longer term bonds
because of their heightened risk
I Relationship between long and short rates:
it + ite+1 + . . . ite+n−1
in,t = + ln,t
| n
{z } |{z}
Liquidity Premium
Expectations Hypothesis

I The liquidity premium, ln,t , is increasing in the time to

maturity
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A First Look at Quantitative Easing and Unconventional
Monetary Policy

I The interest rates relevant for most investment and

consumption decisions are long term (e.g. mortgage) and
risky (e.g. Baa corporate bond)
I Conventional monetary policy targets short term and riskless
interest rates (e.g. Fed Funds Rate)
I Out theory of of bond pricing helps us understand the
connection between the these different kinds of interest rates

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Monetary Policy in Normal Times

I Think of a world where the liquidity premium theory holds

(with a fixed liquidity premium)
I A central bank lowers (raises) short term interest rates and is
expected to keep these low (high) for some time
I This ought to also lower (raise) longer term rates to the
extent to which longer term rates are the average of expected
shorter term rates
I Holding risk factors constant, substitutability between bonds
means that riskier yields also ought to fall (increase)
I Simulation:
I Consider 1 period, 10 year, 20 year, and 30 year bonds
I Fixed liquidity premia of 1, 2, and 3
I Short term rate is cut from 4 to 3 persistently
I Simulate yields for 30 quarters (one-fourth of a year)

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Theoretical Simulation

No Cut Rate Cut

8 8

7 7

6 6
Yields

Yields
5 5

4 4

3 3
0 10 20 30 0 10 20 30
Quarters Quarters
Short Rate
10 Year
20 Year
30 Year

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Monetary Loosening and Tightening in Historical Episodes

11.0000 10.0000

10.0000 9.0000
8.0000
9.0000
FFR 7.0000 FFR
8.0000 AAA 6.0000 Aaa
7.0000 Baa 5.0000 Baa
Mortgage 4.0000 Mortgage
6.0000
10 Yr Treasury 3.0000 10 Yr Treasury
5.0000 2.0000

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Monetary Loosening and Tightening in Historical Episodes

9.0000 8.0000
8.0000 7.0000
7.0000
6.0000
6.0000
FFR 5.0000 FFR
5.0000
Aaa 4.0000 Aaa
4.0000
3.0000 Baa 3.0000 Baa
2.0000 Mortgage 2.0000 Mortgage
1.0000 1.0000
10 Yr Treasury 10 Yr Treasury
0.0000
0.0000
2000-12-01
2001-01-01
2001-02-01
2001-03-01
2001-04-01
2001-05-01
2001-06-01
2001-07-01
2001-08-01
2001-09-01
2001-10-01
2001-11-01
2001-12-01
2002-01-01
2002-02-01

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Term Structure Puzzle?
I If you look at last two pictures, in the 1990s other rates
tracked the FFR reasonably closely, but this falls apart in the
2000s
I This has been referred to as the term structure puzzle and is
discussed in Poole (2005)
I From perspective of expectations hypothesis, would expect
longer maturity, riskier rates to move along with shorter
maturity rates. Not what we see in 2000s
I But two key issues:
I Forecastability: if people expected the Fed to raise rates
starting in 2004/2005 from the perspective of 2002/2003, this
would have been incorporated into long rates before the FFR
started to move. Most people think Fed policy has become
more forecastable
I Persistence: behavior of long rates depends on how persistent
changes in short rates are expected to

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Unconventional Monetary Policy
I In a world where Fed Funds Rate is at or very near zero,
conventional monetary loosening isn’t on the table
I Unconventional monetary policy:
1. Quantitative Easing (or Large Scale Asset Purchases):
purchases of longer maturity government debt or risky private
sector debt. Idea: raise demand for this debt, raise price, and
lower yield. See here
2. Forward Guidance: promises to keep future short term interest
rates low. Idea is to work through expectations hypothesis and
to lower long term yields immediately. See here
I Ben Bernanke: “The problem with quantitative easing is that
it works in practice but not in theory”
I Under expectations hypothesis, cannot affect long term yields
without impacting path of short term yields
I Must either impact liquidity premium or be a form of forward
guidance

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