Course Project Combine all the research and data you have completed for the Course Project assignments from Weeks 1–4. Do not just copy and paste previous assignments. Rather, analyze and present your

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Government Securities

Jessica Arroyo

South University

FIN 2030

4/18/2021

Government Securities

Pure Expectations Theory

The pure expectations theory presents that future rates are exclusively represented by forward rates. Simply, the framework asserts that the term structure indicates the future expectations of the market based on short-term rates. As an illustration, a rising term structure slope represents rising interest rates in the short term. The theory examines the long rates of interest and presents that the rate arises from the expected short-term rates of interest’s average (Azar, 2018). In other words, the expectations theory associates the long-term rate of interest with a certain risk premium based on the average of the short term. The theory is considered a fixed-income theory and significantly uses the interest rate term structure to explain future rates. When it comes to the yield curve, the curve depends on the present rates (short-term) and the interest rate expected after some time.

Pure Expectations Theory Explanation

For investors, their expectations regarding the expectation’s theory depend on what is being evaluated. In most cases, the speculators assess the yield curve based on the interest theory via the pure expectation’s theory. For instance, the current annual interest rate added to the expected annual rate of interest make up a two-year rate of interest. This maturity presents the differences which the theory explores and expounds on regarding the securities and yields (Azar, 2018). In this sense, the theory presents that the investors usually have no maturity preference when it comes to yields and the periods of maturity applied, in this case, weigh equally. The pure expectations theory is a core framework for investors in dealing with government securities.

US Treasury Yield Curve

The rate of interest yield presents a sloping upward curve, which is an important aspect for investors. When the curve slopes forward, it is interpreted as a situation where the investors consider a future rise of the interest rate of the US treasury yield. Based on the pure expectation’s theory, the yield curve indicates an expected future rise, which investors rely on to make decisions concerning their investment activities. However, when the investors expect a future increase in the interest rate, there is usually an upward sloping from the treasury yield. The curve explains the absence of premiums for the maturity of the yields.

Municipal and Corporate Bonds

The approach also applies when investors are dealing with corporate and municipal bonds. However, the municipal bonds display certain similarities with treasury bill rates in terms of the curve. The municipal bonds present an upward slope based on the pure expectations theory, indicating that the economic interest rate will rise as expected. On the other hand, corporate bonds have an equal interest rate with the treasury bills added to the risk premium involved. Furthermore, the risk premium relies on the issuer’s risks and the default risk that comes with the corporate bond. Therefore, corporate bond yields follow the same path as treasury yields.

Yields and Maturities

Since the curve associated with the risk is sloping upwards, there is an increase in maturity, leading to a security yield increase. Applying the pure expectations theory, in this case, indicates that the rate of interest will go up (Murphy, 2020). Treasury bills are expected to be the most secure because they usually come with no default risk. From the table below, it is evident that the US T-bills are decreasing in terms of yield. The fact the treasury bills come with no default peril makes it a core and benchmark factor in dealing with securities. For this reason, T-bills are the most significant of the securities. Secondly, for municipal bonds, when the time period is extended, the municipal bond’s yield also increases. On the other hand, corporate yields might be higher when pitted against municipal bonds because there is a rise in the expected risk.

Table 1 Example

Preferred Security and Justification

When dealing with T-bills, municipal bonds, and corporate bonds, the risks and returns are usually considered proportional. For this reason, opting for a portfolio will rely on a wide range of aspects. For example, the risk-taking ability of an investor is what determines their option depending on what they want. For a portfolio, I would choose corporate securities and treasuries for the short term. The securities provide higher returns and interest rate yield as time passes, making them a valuable choice.

References

Azar, S. A. (2018). The Pure Expectations Theory and Quarterly Interest Rate Premiums. https://doi.org/10.5430/afr.v7n1p161

Murphy, C. (2020). Expectations Theory. Retrieved 18 April 2021 from https://www.investopedia.com/terms/e/expectationstheory.asp