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• W2098093308 abstract "The yield curve is shaped by (i ) expectations of the future path of short-term interest rates and (ii) uncertainty about the path. Uncertainty affects the yield curve through two channels: (i ) Investors attitudes toward risk as reflected in risk premia, and (ii ) the nonlinear relation between yields and bond prices (known as convexity ). The way in which these forces simultaneously work to shape the yield curve can be understood in terms of the conditions that guarantee the absence of arbitrage opportunities. Purpose and outline The purpose of the paper is to provide an introduction to the modern theory of the term structure of interest rates using high-school algebra. 1 In order to present the theory correctly, we must take uncertainty seriously. Nevertheless, the source of uncertainty can be modeled quite simply: All uncertainty is resolved by a single flip of a coin. In this setting, we can rigorously present all three forces that shape the yield curve: expectations, risk aversion, and convexity. The analysis is organized around the conditions that guarantee the absence of arbitrage opportunities. The paper is divided into two parts. Part 1 presents material that was largely in- corporated into a Review article. 2 Part 2 completes the analysis, providing material beyond the scope of the Review article. Part 1 begins with an introductory section in which the basic ideas are first devel- oped by the use of an analogy. Next, bond pricing is introduced in a world of perfect certainty, where no-arbitrage conditions are first worked out algebraically. (In this setting, the absence-of-arbitrage conditions are equivalent to the expectations hy- pothesis of the term structure of interest rates.) Next, uncertainty is introduced via the coin flip, and the no-arbitrage conditions for bond prices are worked out again. These no-arbitrage conditions are shown to imply the existence of a risk premium" @default.
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• W2098093308 date "2001-01-01" @default.
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• W2098093308 title "Forces that Shape the Yield Curve: Parts 1 and 2" @default.
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• W2098093308 doi "https://doi.org/10.2139/ssrn.263134" @default.
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