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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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Classic Theories of the Term Structure of Interest Rates

The best-known theory regarding yield curves is based on bond investors’ and issuers’ expectations about future short-term interest rates. The idea is that market participants choose maturities to maximize outcomes over some known time horizon—investors maximize their expected rate of return (i.e., the horizon yield) and issuers minimize their expected cost of borrowed funds.

The conclusions of this expectations theory are quite significant: Yield curves are upward-sloping (or flat, or downward-sloping) when market participants generally expect short-term rates to be rising (or steady, or falling). In particular, the implied forward rate is an unbiased, market consensus, forecast for the ...

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