In the first page, we establish that “the return of a bond over a one-year period is always the one -year rate if the spot rates evolve as implied by the current forward curve”
But in the very next page, (3rd last para, before example 7, third line) they say “if the trader does _ not _ believe that the yield curve will change its level and shape over an investment horizon, then buying bonds with a maturity longer than investment horizon would provide a total return greater than the maturity matching strategy”
At first glance, I gathered the following thoughts:
Return of bond in 1yr period = spot rate ** _ if** _ spot rate follows forward curve. This implies no actual changes. I think you need to look at diagrams to conceptualize this.
Next page talks about changes in the level and shape of the yld curve. Basically, the investor believes that future spot rates (forward curve) implications are outright wrong. ie forward curve is way too steep based on macro econ factors or monetary policy - say the market isnt pricing in expansionary monetary policy (think LOW RATES in short bonds) - investor then BUYS bonds expecting rate levels to fall (again, future spot prices deviate from forward curve, to the downside).
Circling back to #1, yes, bond return = spot rate IF the forward curve is spot on. (get it?) If the forward rate is wrong (aka the market (other investors) itself is mispricing bonds), there’s an investment opportunity there for active bond managers to exploit.
I understood why the one year return would be equal to the one year spot, _ no matter what the maturity is _. (This happens when spot curve is constant).
I also understood active management, if you anticipate _ changes in expected spot curve _.
However, what I don’t understand is, them saying you can get 2 while condition 1 applies!
They dont contradict each other - you are missing the implied “meaning” behind **if** in #1. IF spot follows forward curve then - IF NOTHING CHANGES, FUNDAMENTALLY, yes, spot is your return, HOWEVER, if spot does not follow forward, investors may exploit it by investing based on their forecasts…
Remove variables from #1 and engrave the theory in your brain… move on to #2 and remember, the forward curve isnt always correct when it comes to forecasting future spot rates.
If future dividend growth forecasts are correct, the value of a stock, based on Gordon growth model, will be correctly calculated.
if the growth input is not correct, the actual value of a stock will deviate from your model.
Yes, output from GGM = value of stock. Now enter the real world, where few things are static, and you have deviations. Same with spot rates and forward rates - if the forward rate doesnt accurately depict future spot rates, or your forecast of future spot rates, you have an investment opportunity.