The Expected Holding Period Return, The Term Structure of Interest Rates and Investment in the Government of Canada Bond Market

THE OBJECTIVES of this thesis are threefold. First, an analysis of the Government of Canada bond market is undertaken with a view to ascertaining which of the extant theories of the term structure of interest rates is most representative of reality. Second, theoretically optimal investment strategies for investors constrained to this market are developed and third, what is theoretically optimal is compared with the portfolios which the Canadian chartered banks are actually holding. With respect to the first objective, the thesis is unique in a number of important respects. First, the unbiased expectations, liquidity preference and market segmentation theories of the term structure are restructured in terms of a holding period return concept in a more complete fashion than heretofore. Second, uncertainty, both in terms of a variance about an expectation and the more theoretically complete covariance with the market, is explicitly introduced into the analysis and the theories of the term structure, then viewed in the context of payments for risk undertaken. Third, investor horizons of 3 months through 5 years are employed in hopes of isolating certain market segments, and fourth, a procedure is developed for at least partially compensating for unanticipated interest rate movement, a problem which has given classical yield type term structure researchers a problem for some time. The analysis itself proceeds in the following fashion. Government of Canada bond data for the period January 1, 1949 through January 1, 1969 are utilized to generate expected holding period returns on instruments of maturity 3 months through 20 years in 3 month intervals for investor horizons of 3, 6, 12, 24 and 60 months, respectively. The results are then compared with the restructured models of the term structure and with various risk parameters. The conclusion is that there is strong evidence to support the existence of a multiple horizon market with a short horizon (3 months or shorter) and probably a series of longer horizons. The Canada market can not on the basis of this research be construed as segmented in the very rigid Culbertson sense, however, but rather should be viewed in the preferred habitat sense articulated by Modigliani and Sutch. The second objective is to develop an optimal portfolio strategy for a short horizon investor constrained to the government bond market, a market now construed as possessing multiple habitats only one of which is short. The third objective is to compare this strategy with that actually undertaken by the chartered banks, whom, it is argued, are the best institutional example of a short horizon investor. The optimal strategy is argued to be a well diversified portfolio of short bonds and, in comparing this with what the banks in aggregate actually held, a discrepancy is observed. The banks seem to be holding an excess of the longer instruments. A number of explanations for this are then advanced; in particular, a desire on the part of the government that the banks maintain the long end of the market, uncertainty with respect to bank holdings in the 3 to 5 year range and the bank's own view ofthemselves as superior interest rate forecasters.