Chapter 6 Chapter 6

15
EXPECTATION THEORY: As per this theory, the shape of the yield curve depends on
investors expectations. If they expect that in future the interest rates will rise, the
curve will have positive slope; if they expect that in future the interest rates will fall,
the curve will have negative slope. If the expectation is not much change in interest
rates, the shape of the yield curve will be flat.
LIQUIDITY PREFERENCE THEORY: As per this theory, interest is reward for parting
with the liquidity. This theory is based on the assumption that the investors have
preference for liquidity; longer the maturity, more the moving away from the
liquidity.
This theory provides the explanation only for normal yield curve. The theory states
that for the longer maturities, the yields should be higher. Two reasons are advanced
for this (i) longer maturities means more parting with the liquidity and (ii) longer
maturities cause more risk and hence the higher risk premium.
FORWARD RATES
This concept is based on Expectation theory.
Forward rate is the interest rate that we expect, today, to prevail in the market after
certain period.
Forward rate for first year is the rate of interest that expect, in the beginning of the
1 st year, to earn on our investment made in the beginning of the 1 st year till the end
of 1 st year. It is also referred as spot rate for 1 st year.
Forward rate for second year is the interest rate that we expect, today, to prevail in
the market in 2 nd year. In another words, we can say that it is rate of return that we
expect (today) to earn on our investment made in the beginning of 2 nd year till the
end of 2 nd year.
Forward rate for 3 rd year is the interest rate that we expect, today, to prevail in the
market in 3 rd year. In another words, we can say that it is rate of return that we
expect (today) to earn on our investment made in the beginning of 3 rd year till the
end of 3 rd year.
Forward rate for 4 th year is the interest rate that we expect, today, to prevail in the
market in 4 th year. In another words, we can say that it is rate of return that we
expect (today) to earn on our investment made in the beginning of 4 th year till the
end of 4 th year.
And so on…………………..
We can calculate the forward interest rate either with the help of wealth ratio or
using the basic concept of valuation (The basic concept of valuation is that the
market price of any asset is equal to present value of all future cash flows).
Q. No. 23 : The following is the list of prices of zero coupon bonds of various
maturities. Calculate the yields to maturity of each bond.