ChartForex and the Yield Curve: Understanding Interest Rates

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Whether one is a technical or fundamental trader, there is little disagreement that forex prices depend very strongly on the interest rate differentials between currencies. We are most used to measuring this differential in terms of the basic rate of the central bank. Although other factors like the liquidity of the transmission mechanism, the capitalization, and profitability of the banking sector, as well as the openness of the financial system play a great role in determining the relevance of interest rates with respect to forex quotes, most of the time we regard the central bank rate as the benchmark for the future performance of a currency. Yet the central bank interest rate in general only determines the overnight rate in the money markets, while we know that for most us, individual investors, as well as corporations, overnight transactions are rare. So how does the central banks interest rate decisions get transmitted to the wider economy? How does the main rate of a central bank influence the 3-year borrowing of a firm, or the 30-year mortgage contract of an ordinary citizen?

It is clear that we need a better understanding of the term structure of interest rates in order to understand how interest rates determine economic activity on a large scale. Since this relationship is best defined in the yield curve, in this article we'll examine it in detail, and the various theories that define what leads investors to favor or disfavor a particular maturity on the scale. In following sections, each of the various interest rate theories will be discussed in their own articles as well.

Interest rate definition

Interest rates are defined as simply as being the cost of borrowing. In defining an interest contract, we use two concepts to explain its terms. One is the rate, the other is the maturity of the payment. Of these two, the rate is the payment that must be made to the lender at regular intervals, and maturity is the time at which the borrowed sum must be returned to the lender.

What is the yield curve?

Yield curve is the term used to describe the maturity-interest rate structure of a borrowing transaction, usually that of government paper, in a given currency. It is created by plotting the interest rates available against the various maturities at which borrowing is possible, and then combining the values with a line, which will resemble a curve. The relevance of the yield curve for economic activity cannot be overstated. Since government securities are regarded as safe assets with maximum liquidity in most circumstances, all other kinds of borrowing transactions, and the risk involved in them are priced and evaluated in accordance with the yield curve of government securities. So if you own a business, and would like to receive credit at a particular maturity for expansion, the lender will desire to know the interest rate of the government security at the same maturity even before knowing anything about your firm, and will always charge you a rate above what it could receive from investing government paper. Since investing in government paper would involve practically no risk, the borrower would demand a premium for taking on the additional risk.

The yield curve is one of the best indicators of current economic conditions as perceived by the bond market. It is crucial for the pricing of many financial derivatives, as well as consumer credit and mortage rates for ordinary borrowers; as such, any analysis of a national economy will incorporate the yield curve data in order to reach at more solid and reliable conclusions.

What is the significance of the yield curve for forex traders?

The benchmark interest rates of 2-year bonds, for example, provide us some hints on the credibility of central bank policies as perceived by the market, via expected inflation in the future. The yield curve, (or term structure) is also a reliable indicator of economic cycles. Before economic recessions, it is reversed, that is, shorter-term maturities suffer higher interest than the longer term, hinting at reduced central bank rates (as well as other things depending on how you interpret them. Understanding the term structure allows us to predict future rates with greater accuracy and confidence, a crucial goal for any trader due to the importance of this concept for most traders.

Upward slopes are associated with future inflation (appreciating currency, rising yields, growth), while downward slopes are related to depreciation, and economic contraction. The flat yield curve can be either a sign that the yield curve is transforming to another type (upward sloping to downward, and vice versa), or a protracted period where the present conditions will be maintained (such as inflation, yields, and growth). The forex market reacts to a flat curve in one currency on the basis of developments in other economies. The humped yield curve is a sign that some period of uncertainty, volatility, or rapid changes may be in order. The flat yield curve is often encountered where the market is expecting rates to reverse direction after a short while.

Since currency trends are strongly dependent on perceptions about future rates, as well as present yield differentials between nations, comparing the yield curves of two nations will give us a better idea on the attractiveness of a particular currency for a particular profile of investors. Many hedge funds, for example, are active in the short-end of the yield curve, and also trade the spot forex market, so their behavior will tend to reflect differentials in the short-term market. Others, such as mutual funds, tend to seek safety over risk in usual circumstances, and their unleveraged funds will tend to be concentrated a bit further to the right of the yield curve (towards longer maturities).

Other observations to help understand the interest rate theories

Apart from the shape of the yield curve, there are three critical observations that will help us understand the interest rate theories to be discussed below

Rates of different maturities move together: We know that interest rates on three month, one year, and two year contracts usually move together, and not independently.
When short rates are low, the curve slopes upward, and when they are long, the slope of the curve is downwards: Most of us are familiar with this fact, and we often tie it to higher interest rate expectations after a period of stimulus, and accommodating monetary policy for example. Conversely, we anticipate a period of lower rates in the future after rates remain high for a period. In other words, a yield curve with high short term rates will be sloping downwards steeply in most cases.
Yield curves slope upwards in a majority of cases.
Since traders are aware of the importance of interest rates in determining forex trends, it should be obvious that understanding the yield curve, and what it signifies can be very useful in trading decisions. We'll handle each interest rate theory in detail in its own article, but before going further, let's examine them in an overview in order to stay in touch with the big picture.

Pure Expectations Theory (PET)

The pure expectation theory is the most straightforward and easy to understand of interest rate theories, and is also the most intuitive for traders. It simply assumes that qualitatively there's no difference between a three-month maturity interest rate contract, and one with a maturity of three years. All that matters is the expected interest rate over the maturity term, as perceived by market participants on the basis of real and predicted interest rates. In mathematical terms, the yield of a long-term interest rate contract will be the geometric mean of yields on shorter-term contracts adding up to the maturity term of the long term contract.

In sum, longer term yields are merely a projection of short term rates to the future without any specific properties setting long term rates apart from short-term ones with respect to risk or predictability. Today's assumptions by market participants are perfect predictors of future rates, so there's no need for any premium when buying or selling debt securities on longer maturities. Read more about the pure expectations theory.

Liquidity Preference Theory (LPT)

The pure expectations theory has a clear deficiency in that market participants are not always right about the future. Also, the geometric mean of short term yields across the term structure is rarely a perfect indicator of the future rates over the long term. We often observe that longer-term yields incorporate a premium over the geometric mean, termed the liquidity premium, which is the subject of the liquidity preference theory for the most part.

In mathematical terms, LPT differs in its calculation of the yield curve only with respect to an additional risk premium (rp) component added to the expected rate of the pure expectations theory. Read more about the liquidity preference theory

Market Segmentation Theory (MST)

This theory takes LPT and drives it one step further away from PET by stating interest rate contracts across the term structure are not substitutable. The dynamics creating the interest rate equilibrium for each maturity term are born of independent factors, and as such, the PET is invalid. An investor deciding to purchase a bond, whether public or private, does not regard the short-term/long-term paradigm merely as a matter of convenience, but as a fundamental factor influencing investment strategy, liquidity needs, and of course supply and demand.

This approach to the term structure can explain the sloping nature of the yield curve. But since it assumes that term structures depend on independent, it fails to explain why rates across different maturities move simultaneously, albeit often by differing quantities. Read more about the market segmentation theory

Preferred Habitat Theory (PHT)

Finally, the preferred habitat theory attempts to solve the shortcomings of MST by positing that investors have a preferred habitat for their investments. Although interest rate expectations do indeed determine the rate-maturity structure at a basic level, investors demand a higher premium, in most cases, for longer maturity debt, due to their preferred habitat in the left-hand side of the yield curve (i.e. the short term). Thus, although interest rate expectations do play an important role in determining the shape of the yield curve (and as such, maturity terms are substitutable to an extent), there is also a powerful non-substitutable component determining the term structure.

The PHT is generally regarded as the most realistic among the four. Read more about the preferred habitat theory

The trader will derive the greatest benefit from this discussion if he gets used to the two concepts of preferred habitat, and risk premium. Especially the latter will be encountered often in financial discussions, and it is the duty of any trader to make it a part of his life.
Attachments
what we want: 1+1+1+1+1+1+1+1+1=9 <3
what market delivers: 1+2+8+7-4+0-5+8-4-5+1=9 :problem:


Re: Forex and the Yield Curve: Understanding Interest Rates

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Pure Expectations Theory


The simplest of the interest rate theories is the pure expectations theory which assumes that the term structure of an interest contract only depends on the shorter term segments for determining the pricing and interest rate of longer maturities. It assumes that yields at higher maturities (such as that of 5,10, or 30 year bonds), correspond exactly to future realized rates, and are compounded from the yields on shorter maturities. In other words, buying a ten year bond is equal to buying two five year bonds in succession; you're as safe in a ten-year as in a five-year bond. At a cursory consideration, this should indeed be the case. For instance, with the government securities in the U.S. the only risk and rewards are born of the interest rate return on the lent amount. There is no significant risk of default associated in the transaction. PET also supposes that expectations of future rates coincide exactly with future rates realized in time. The market is a perfect predictor of future supply and demand. The pure expectations theory is in some ways similar to the efficient market hypothesis, in that it assumes a perfect market environment where expectations are just about the only determinant of future prices.

Yield calculation

From these basic assumptions, the pure expectations theory (PET) posits that future interest rates on longer maturities depend only on the rates of previous periods. To calculate the yields on a 3-year bond, for example, all that you need to do is to take the geometric mean of one-year yields on the first, second, and third years; there's no external component independent of the yields that goes into the calculation of the yield curve. The term structure is substitutable. A contract on a three-year term serves exactly the same purpose as one on 3-months aside from the difference in interest rates, and as such, it is valued as if made of successive contracts combined to form the rate on the third year. You can either buy a two-year bond, or two one year bonds successively, the result will be the same with respect to return.

Limitations in the pure expectations theory

It is not hard to see that the pure expectations theory is similar to a pure intellectual exercise. It is rare to achieve the perfect results of this theory where today's predicted rates over different maturities exactly match future realized spot rates. In addition, although the theory explains the simultaneous movement of rates, and also the relationship between the long and short terms well, it does not say anything about why the yield curve has an upward slope most of the time, that is, why longer term maturities command a higher interest rate in comparison to the short term. Since we noted that all maturities are equivalent in function, the slope is equally likely to be upwards as downwards (in tune with the boom-bust cycle, and rising and falling future rate expectations.), but this is not the case. Clearly, investors attach a higher risk to longer maturities due to some intrinsic factor not explained or predicted by the pure expectations theory
what we want: 1+1+1+1+1+1+1+1+1=9 <3
what market delivers: 1+2+8+7-4+0-5+8-4-5+1=9 :problem:

Re: Forex and the Yield Curve: Understanding Interest Rates

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Liquidity Preference Theory


In the previous chapter, we noted that the pure expectations theory (PET) cannot explain why short-term yields are typically lower than longer-term yields most of the time. Since PET assumes rates across the maturity spectrum to be equivalent in quality and function, we'd expect a homogenous distribution of both downward and upward sloping yield curves, but we most of the time get the upward slope. The liquidity preference theory (LPT) was devised to explain this situation.

This theory introduces the concept of a risk or liquidity premium to our equation for predicting future rates. It posits that, while the term structure (the mathematica; formula defining the yield curve) of interest rate contracts are substitutable for the most part for different maturities (i.e. a ten-year bond is partially a substitute for two consecutive five-year bonds purchased), there is a risk factor that leads to the yield curve to be upward sloping most of the time. Thus, even if the interest rate expectations were the same across the entire spectrum of maturities, the yield curve would still be sloping upwards due to the inherent risk of acquiring a debt instrument at a longer maturity.

The risk premium is the result of lesser liquidity of long maturity interest rate contracts, as well as the higher risk of default the more we delay the date the repayment. In a two-way relationship, the lower marketability of long-term instruments leads to their lower liquidity, and that also contributes to a higher interest rate on a consistent basis.

Liquidity preference theory is essentially an improved version of the pure expectations theory. It maintains the former's postulate that different maturities are substitutable, but adds that they are only partially so. There is a small qualitative difference between long and short term debt instruments, quantified in the risk premium, which leads to the sloping upward curve, and the observed phenomenon of higher rates at higher maturities most of the time.

The risk premium of the LPT assumes that all investors have similar preferences, and for practical, and easily understood reasons, choose to demand additional compensation at higher maturities for higher risk. But what if different investors do not equally value each segment of the maturity structure at the same degree? In other words, what if there are inherent, qualitative differences between maturities as perceived by investors, which leads to the conclusion that different maturities are not substitutable to each other in terms of the role that they play in investor portfolios? This supposition is the subject of the market segmentation theory discussed in the following section.
what we want: 1+1+1+1+1+1+1+1+1=9 <3
what market delivers: 1+2+8+7-4+0-5+8-4-5+1=9 :problem:

Re: Forex and the Yield Curve: Understanding Interest Rates

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Market Segmentation Theory




The third approach that we'll discuss in this article is radically different from the two previous ones that we've examined. Both the liquidity preference theory, and the pure expectations theory depend strongly on the presumption that debt instruments of different maturities are only distinguished by their return, and that purchasing a two-year bond is essentially equivalent to buying two one year bonds in succession, since the market efficiently predicts future rates in the time horizon in question. Market segmentation theory (MST) does away with this approximation (since we all know that future rates as predicted by bonds and realized in the spot market do not exactly match each other), and discusses each separate maturity term as being independent of the others. In other words, we should not speak of a bond market, but rather of two-year, five-year, ten-year bond markets, since the roles played by these instruments are not equivalent in any way. Each maturity term is fulfilling a different function, with a different investor profile, and thus is a unique product, far from being a tool of convenience for those who would prefer to hold a single contract instead of renewing each short term one in succession, as suggested by the expectations theory.

MST posits that each borrower and lender have a particular timeframe in mind when purchasing or selling a debt instrument. An investment bank may be buying or selling a government bond in the short term in order to profit from interest rate changes that could be announced by a central bank. A construction firm may desire to sell ten-year bonds in order to repay them when the construction project is finished and there is abundant liquidity to meet the demands of the creditor. Similarly, a student would prefer to borrow on a long-term basis in order to meet his obligations after graduation, when he'll have ample financial capability to pay his debts.

The market segmentation theory allows us to incorporate the depth of the market into our understanding of the term structure of debt instruments, and in a way, takes the two-dimensional LPT or the expectations theories, and gives them the third dimension of investor preferences. Thus, the risk premium discussed in the context of the liquidity preference theory is not just something demanded by the lender (supply side), but also eagerly provided by the borrower (the demand side) due to his preference for longer term maturities which allow better returns on investments as a result of the greater freedom enjoyed in business decisions and planning (you can plan for the longer term since repayment is a long way away from now). A greater number of lenders cluster around the short-side of the yield curve due to lower risk and higher liquidity, leading to lower yields, while a greater number of borrowers tend to group at longer maturities, due to the greater flexibility that they enjoy while making use of the funds, which leads to greater demand for borrowing, and higher rates, as a consequence. This supply demand segmentation of the market leads to the observed slope of the yield curve where the shorter term maturities are coupled to lower rates most of the time.

The advantage of this theory is that it succeeds where the other two theories fail. It can easily explain while the yield curve slopes upwards most of the time, but does not say anything about why rates move up or down simultaneously across the maturity scale. Since each maturity term constitutes a separate market, we would expect their interest rates to move independently up or down, with no obvious relationship, but that, of course, contradicts the well-known and easily observed relationships in the market.

To combine the market segmentation theory with the better aspects of the liquidity preference theory, the preferred habitat theory was developed, which we'll examine in the next chapter.
what we want: 1+1+1+1+1+1+1+1+1=9 <3
what market delivers: 1+2+8+7-4+0-5+8-4-5+1=9 :problem:

Re: Forex and the Yield Curve: Understanding Interest Rates

5
Preferred Habitat Theory



In our previous discussions of both the expectations theory and the market segmentation theory we noted that both fail to explain some observed phenomena in the market satisfactorily. The preferred habitat theory is a combination, a synthesis of the those two theories created in order to explain the interest rate- maturity term relationship.

The preferred habitat theory posits that although investors prefer a certain segment of the market in their transactions based on term structure (the yield-maturity plot of the debt instrument showing which yield matches which maturity, another term for the yield curve) and risk, they are often prepared to step out of this desired to segment if they are adequately compensated for the decision. But they will never prefer a long term instrument over a short term contract with the same interest rate. Thus, maturity structure does lead to some fundamental differences in investor behavior, but there is always a price at which all maturities will provide the same attractiveness to a potential investor. In other words, a sufficiently high interest rate will lead market actors to attach greater value to a less-preferred, unusual maturity, leading to the usual upward sloping shape of the yield curve. The market is segmented, but only partially so, interest rates do add up over longer maturities, but once again, only in part.

The major conclusions of the preferred habitat theory are as follows:

If the yield curve slopes upward, investors do not expect any major changes in interest rates. Rates may go higher, but they may also remain the same, with the upward slope reflecting the risk premium. In other words, the prevailing conditions are expected to continue (provided that the economy is growing).
If the yield curve is sloping downward, short interest rates are expected to fall. Since at higher maturities we'd expect interest rates to be higher, but get them lower in a downward slope, the only possible conclusion is that rates will fall so much that they will be lower than today's rates even with the risk premium added.
If the yield curve is flat, the market is expecting future rates to come down slightly. Interest rates must fall in the future, so that the yield curve may remain falt even with the risk premium added on top of future prices.
The preferred habitat theory is the modern interest rate theory explaining the yield curve. It was developed in the post-Nixon era to meet the difficulties arising in the fiat currency systems, and remains a valid tool today.
what we want: 1+1+1+1+1+1+1+1+1=9 <3
what market delivers: 1+2+8+7-4+0-5+8-4-5+1=9 :problem:


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