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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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Bond RatingsFitch, too

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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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Conversion Options• A conversion option permits the investor to convert

a security contract into another security

• The conversion yield discount is the difference between the yields on convertibles relative to nonconvertibles.

• CYD = icon – incon < 0