BKM 15: Term Structure of Interest Rates

Question 1

Yield curve

Answer 1

Plot of YTM as a function of time to maturity

Question 2

STRIPS program

Answer 2

Each coupon or principal payment can be sold off separately as a stand-alone zero-coupon bond

Value of whole bond should be same as value of cash flows bought piece by piece

Question 3

Pure yield curve

vs.

On-the-run yield curve

Answer 3

Pure yield refers to zero-coupon treasuries while on-the-run refers to plot of yield as a function of maturity for bonds selling at/near par

Question 4

Spot rate

Answer 4

Yield to maturity on a zero-coupon bond based on today’s rates

Question 5

Short rate

Answer 5

Interest that applies in a future time interval

Question 6

Forward rate

Answer 6

Rate expected to apply at a future date

Question 7

Liquidity premium

Answer 7

Compensates short-term investors for the uncertainty of future prices of long-term bonds

Difference between f_i and E(r_i)

Question 8

Expectations hypothesis

Answer 8

Forward rate equals market rate; liquidity premium = 0

Question 9

Liquidity preference theory

Answer 9

Short-term investors dominate the market so that the forward rate will generally exceed expected rate; liquidity premium is positive

Question 10

Difficulties with inferring expected future interest rates from curves

Answer 10

Existence of liquidity premiums, and the fact that these are not stable over time