8.1) Term Structure interest rates & Bootstrapping (Chapter 15) Flashcards
What is Term Structure of Interest Rates (TSI)?
The relationship between the yields to maturity and term to maturity of a sample of similar bonds
What characteristics of bonds need to be similar for term structure of interest rates? (5)
-risk
-liquidity
-tax rates
-coupon rates
-credit quality
Doesn’t need to be similar → time to _________
o Additional ____________that investor want for additional time on securities is the time ____________
maturity
Return
spread
What does the ‘time factor’/time premium/ time spread/price of time show?
What the market is thinking of the future of the economy, inflation, future interest rates
What bond or category fits the criteria of term structure interest rates? (2)
- Government (The risk factor stays the same with government bonds)
- Zero-coupon bonds (No reinvestment risk and don’t contaminate this pure price of time)
What is the importance of TSI? (3)
- Used to extract spot rates* which are applied in:
o Pricing bonds
o Extracting forward rates
▪ Predict future interest rates and use them to formulate active bond strategies.
▪ Predicting future economic activity and make investment decisions
o Other uses (i.e., estimating inflation, monetary policies)
- Shape of curve changes with changes in __________ rates
- Yields generally move together with ______
- Shape of curve is important to _____________ & economists
interest
time
investors
What is the meaning of the different TSI yield curves? (4)
- Flat yield curve : Investors want the same return for all instruments.
- Upward-sloping yield curve : Investors want higher return for long-term instruments & lower return for short-term instruments.
- Downward-sloping yield curve : Investors want a higher return for short-term instruments and a lower-return for long-term instruments.
- Hump-shaped yield curve : Investors want a lower return for short & long-term instruments and a higher return for medium-term instruments.
What are the two methods of deriving spot rates? (2)
1) Direct observation
2) Bootstrapping
how does the direct observation method work? (3)
1) Works if given a pure yield curve, made of stripped treasury zero-coupon bonds
2) YTM of a ZCB is the spot rate
3) Observe bond yields in the TSI → those are your spot rates
What are the spot rates and how are they calculated?
The YTM of a Zero-coupon bond is the spot rate
What are the characteristics of bootstrapping? (3)
- Only used if not possible to observe the TSI
- Extract spot rates from the dirty curve
- Can’t directly observe spot rates for maturities greater than 1-year and 6 months in South Africa (This is why you have to do bootstrapping)
What are the assumptions of bootstrapping? (2)
1) Assumes an efficient market
2) the market price of a Treasury coupon security (bond) should be equal to the value of the package of zero-coupon Treasury securities (bonds) that duplicates the coupon bond’s
cash flows
What does bootstrapping assume about an efficient market? (1x2)
- Assumes an efficient market:
1) Market prices for bonds are arbitrage free.
2) Arbitrage free means you cannot make profit from reconstituting or stripping.
(From this assumption you can take the formula and derive the spot rate)
What does bootstrapping assume about the market price of a Treasury bond being equal to the value of the package of zero-coupon treasury bonds that duplicates the coupon bond’s cash flows?
Where the yield used for discounting is the spot rate corresponding to the cash flow.