Go to a financial Web site, such as finance.yahoo.com, http://www.google.com/fin

Question

Go to a financial Web site, such as finance.yahoo.com, http://www.google.com/finance, or moneycentral.msn.com. Obtain information on the yields and maturity for:

*U.S. treasuries
*Municipal bonds
*Corporate bonds

Discuss what the pure expectations theory would imply about the yield curve. Compare and contrast the yields and maturities for each of the securities. Discuss which you would hold and why relative to interest rate risk. You must submit your backup in Excel or other supporting documentation showing how answers were reached.

Explanation / Answer

U.S. Treasuries COUPON MATURITY PRICE/YIELD 3-Month 0.000 08/04/2011 0.03 / 0.04 6-Month 0.000 11/03/2011 0.09 / 0.09 12-Month 0.000 04/05/2012 0.18 / 0.18 2-Year 0.625 04/30/2013 100-01½ / 0.60 3-Year 1.250 04/15/2014 100-24 / 0.99 5-Year 2.000 04/30/2016 100-04+ / 1.97 7-Year 2.625 04/30/2018 99-26 / 2.65 10-Year 3.625 02/15/2021 102-28½ / 3.28 30-Year 4.750 02/15/2041 106-04½ / 4.38 The yield curve moves upward as the maturity period is increasing. The difference in yield of bonds is due to risk premium for difference in maturity. The yield for 3 month bond is 0.04 and for 30 years it is 4.38. It shows the direct relationship of yield curve with maturity. Municipal Bonds CURRENT YLD 1-Year 0.302% 2-Year 0.523% 5-Year 1.520% 7-Year 2.203% 10-Year 2.853% 15-Year 3.630% 20-Year 4.159% 30-Year 4.576% Once again the yield curve has the direct relationship of with maturity. For 10 years bond the yield is 2.853 and for 30 years the yield is 4.576. However the yield of US treasury is less than municipal bonds, as it is considered more risky. Corporate bonds It has been proved from the above example that the yield curve has the direct relationship with maturity whether it belongs to US treasury, municipal bond or corporate bond. However the corporate bonds are the most risky among three therefore it will have more risk premium, therefore the yield of similar maturity for corporate bonds will be higher than other two. The expectancy theory As per the pure expectation theory, the bondholders look the prices and interest rates of bond related to their expectations about interest rate of bonds in the market in future. According to their perception the maturity period does not have any impact on risk, it means that both long term and short term debts are of the same risk, therefore the interest rate should be the same. According to this theory there would not be any premium for risk due to difference in maturity and the rate of interest for long term debt would be simply a weighted average of current and expected future interest rates of short term bonds.

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