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David Hatfield Project 2 FINA 3144 1 Problem 1: Understanding Interest Rate Movements 1. January 1980: a.

January 1980 Yield Curve: In the short-term the shape of the yield curve has a slight rise and then fall. Over the long term the bond yield stabilizes and has a very small decrease until the bonds maturity date. i. Short-term average yield – 11.4801% ii. Intermediate average yield – 10.7749% iii. Long-term average yield – 10.6780% b.Spread between the rates: i. Short-term to Intermediate yield spread – 0.7052% ii. Short-term to Long-term yield spread – 0.8021% iii. Intermediate to Long-term yield spread – 0.0969% 2. March 1980: a. March 1980 Yield Curve: In the short-term the shape of the yield curve suggests a much higher yield compared to the January yield curve. With-in the first 5 years the yield curve rises and falls dramatically. Over the longterm the bonds yield curve has a negative slope and remains negative until maturity. i. Short-term average yield – 14.1183% ii. Intermediate average yield – 12.2325% iii. Long-term average yield – 11.7874% b. Spread between the rates: i. Short-term to Intermediate yield spread – 1.8858% ii. Short-term to Long-term yield spread – 2.3309% iii. Intermediate to Long-term yield spread – 0.4451% 3. April 1980: a. April 1980 Yield Curve: In the short-term the shape of the yield curve has a slight rise and fall with-in two years. The bonds yield then falls slightly until the fifth year, and then the yield rises gradually for the remainder of the bonds life. i. Short-term average yield – 10.3241% ii. Intermediate average yield – 10.3433% iii. Long-term average yield – 11.0763% b. Spread between the rates: i. Short-term to Intermediate yield spread – 0.0192% ii. Short-term to Long-term yield spread – 0.7522% iii. Intermediate to Long-term yield spread – 0.7330% Summary: Bonds issued at different points in time can have varying interests rates in both the shortterm and long-term. The three months that were studied have shown me that the yield for bonds can change substantially in the matter of a month. Also within the first year the bond yield is very volatile but almost returns to where it started. After the fifth year the bonds yield curve flattens out and becomes much less volatility than before the fifth year.

2 Problem 2: Risk And Return Part 1: 1-month yields of all time: Variance: 0.0008083 Standard Deviation: 0.028431 5-year yields of all time: Variance: 0.0006332 Standard Deviation: 0.025164 15-year yields of all time: Variance: 0.0004151 Standard Deviation: 0.020374 30-year yields of all time: Variance: 0.0004866 Standard Deviation: 0.022059

3 Part 2: 1970-1974 1-month yields: Variance: 0.0002764 Standard Deviation: 0.016624 Average: 5.6481% 5-year yields: Variance: 0.0000631 Standard Deviation: 0.007946 Average: 6.6781% 15-year yields: Variance: 0.0000357 Standard Deviation: 0.005977 Average: 6.8880% 30-year yields: Variance: 0.0000343 Standard Deviation: 0.005855 Average: 6.9846% 1975-1979 1-month yields: Variance: 0.0004267 Standard Deviation: 0.020657 Average: 6.4503% 5-year yields: Variance: 0.0000924 Standard Deviation: 0.009614 Average: 7.8073% 15-year yields: Variance: 0.0000452 Standard Deviation: 0.006721 Average: 8.0178% 30-year yields: Variance: 0.0000365 Standard Deviation: 0.006039 Average: 8.0760%

4 1980-1984 1-month yields: Variance: 0.0006645 Standard Deviation: 0.025778 Average: 10.4905% 5-year yields: Variance: 0.0001881 Standard Deviation: 0.013714 Average: 11.9755% 15-year yields: Variance: 0.0001175 Standard Deviation: 0.010840 Average: 12.1223% 30-year yields: Variance: 0.0001029 Standard Deviation: 0.010142 Average: 12.2203% 1985-1989 1-month yields: Variance: 0.0003260 Standard Deviation: 0.018054 Average: 5.7833% 5-year yields: Variance: 0.0001841 Standard Deviation: 0.013570 Average: 7.8029% 15-year yields: Variance: 0.0001146 Standard Deviation: 0.010706 Average: 8.5026% 30-year yields: Variance: 0.0001252 Standard Deviation: 0.011191 Average: 8.5892%

5 1990-1994 1-month yields: Variance: 0.0003249 Standard Deviation: 0.018025 Average: 4.4565% 5-year yields: Variance: 0.0001289 Standard Deviation: 0.011351 Average: 6.8105% 15-year yields: Variance: 0.0000316 Standard Deviation: 0.005622 Average: 7.9540% 30-year yields: Variance: 0.0000503 Standard Deviation: 0.007093 Average: 7.7385% 1995-1999 1-month yields: Variance: 0.0000646 Standard Deviation: 0.008040 Average: 4.6673% 5-year yields: Variance: 0.0000411 Standard Deviation: 0.006414 Average: 5.9158% 15-year yields: Variance: 0.0000383 Standard Deviation: 0.006191 Average: 6.5100% 30-year yields: Variance: 0.0000335 Standard Deviation: 0.005789 Average: 6.2227%

6 2000-2004 1-month yields: Variance: 0.0003512 Standard Deviation: 0.018740 Average: 2.6218% 5-year yields: Variance: 0.0001527 Standard Deviation: 0.012358 Average: 4.2057% 15-year yields: Variance: 0.0000093 Standard Deviation: 0.003044 Average: 6.0937% 30-year yields: Variance: 0.0000062 Standard Deviation: 0.002492 Average: 5.4196% 2005-2007 1-month yields: Variance: 0.0000916 Standard Deviation: 0.009571 Average: 4.1178% 5-year yields: Variance: 0.0000149 Standard Deviation: 0.003866 Average: 4.4559% 15-year yields: Variance: N/A Standard Deviation: N/A Average: N/A 30-year yields: Variance: 0.0000038 Standard Deviation: 0.001947 Average: 4.8760%

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Summary: This exercise has shown me, as time increases the variance and standard deviation of the bonds yield decreases, but the average yield typically increases. I believe this occurs because as time increases the yield curve typically flattens and becomes more stable. This means over months and years the long-term bond rates will change very little. As time decreases the bonds become more volatile and there is a larger fluctuation in the yields, causing a larger variance and standard deviation, but also a smaller average.

8 Problem 3: Pure Expectations Theory Time in Years 1 2 3 4 5 6 7 8 9 10
6% 5% 4% 3% 2% 1% 0% 1 2 3 4 5 6 7 8 9 10 1 Year Interest Rates Arithmetic Mean Interest Rates Geometric Mean Interest Rates

1 Year Interest Rates 1% 2% 3% 4% 5% 5% 4% 3% 2% 1%

Arithmetic Geometric Mean Mean 1.000% 1.000% 1.500% 1.414% 2.000% 1.817% 2.500% 2.213% 3.000% 2.605% 3.333% 2.904% 3.429% 3.040% 3.375% 3.035% 3.222% 2.898% 3.00% 2.61%

Explanation: Shown above is a plot of the one-year interest rates, as well as the arithmetic and geometric means of the one-year interest rates over time. The yield curve for the averages follow along with the rates of the one-year interest rates, when short-term interest rates are rising the yield curve rises and falls when the one year interest rates are falling. The pure expectations theory states that bonds of different maturities are perfect substitutes. Because the expected return of the one-year interest rates and the averages of the rates do not equal, then these bonds are not perfect substitutes.