1. Basic principles
    1. Money markets
      1. Loans of less than a year
    2. Bond markets
      1. Loans with maturity longer than a year
    3. Same principles of valuation apply to both
    4. A bill or a bond is a contract to pay a fixed sum of money in the future so the current price determines the yield on the bond
    5. Yield on a multi period bond (yield to maturity or redemption yield) depends on three main factors
      1. Price of the bond
      2. Payments made
        1. Coupon
        2. Maturity value
      3. Time to maturity
      4. In order to know how prices change as yields alter we use a formula known as the Macaulay Duration (D) which is a weighted average of coupon payments
        1. http://en.wikipedia.org/wiki/Bond_duration#Macaulay_duration
  2. Background to bond market
    1. Types of bond
      1. Government. By far the largest part of the market
      2. Corporate bonds
        1. Big in the US. Because of Glass Steagall and state based banking system until the nineties.
        2. Increased in eye eighties because of. The junk bond phenomenon
        3. Increasedmore recently in Europe with advent of the Euro and national banks were less able to finance Trans-continental borrowing
  3. Term structure of interest rates
    1. Different theories
      1. Expectations theory: value is average of all years' returns to maturity
        1. Doesn't price in any risk changing in the period of bond
        2. Relies on notion that short. And long are perfect substitutes
      2. Liquidity preference theory: that there is a preference for shorter than longer maturity bonds
        1. Buyers will demand a liquidity premium as maturity badges increase
      3. Preferred habitat theory: not everyone prefers short over long.
        1. So though the is a single market for short and long term bonds, different players prefer different time scales on that spectrum.
        2. Reflected by different maturity dates in gilt. Issues (few gilts issues in 5-15 year. Maturity)
      4. Segmentation theory: there a effectively different markets with different players and own patterns of supply and demand
    2. Yield curves
    3. Testing the term structure
      1. Most empirical tests start with testing the expectations theory
        1. Most influential early tests were those by Meiselman who used a model of adaptive expectations
          1. Approach was to compare actual rates with forecast rates and see whether rates changed when there was a forecasting error
        2. From late 70s onwards the focus shifted to models of rational expectations
          1. Key work in this area by Robert Shiller
          2. Shiller's results
          3. Shiller found that the bond market appeared to be out efficient and that expectations theory worked quite wel
          4. However,