BKM15

Question 1

spot rate

Answer 1

the interest rate that applies from time 0 to time t

can be thought of as the yield to maturity on zero-coupon bonds

Question 2

short rate

Answer 2

interest rate that will apply during a future time interval

Question 3

forward rate

Answer 3

expected future short rate

Question 4

terminal value

Answer 4

“A” is invested for “n” years at a rate of “R”, compounded “m” times per annum is: A * (1 + R/m)^mn

Terminal value if compounded continuously: Ae^Rn

Question 5

Yield curve

Answer 5

graph that shows relationship between interest rate and time to maturity

pure yield curve

-curve is generally upward sloping but can deviate

Question 6

2 theories of term structure/shape of the curve

Answer 6

expectations hypothesis

liquidity preference theory

Question 7

Expectations Hypothesis

Answer 7

the forward rate = expected future short rate

-expected yields on bonds of different maturities reflect market expectations of future short rates

Question 8

short term and long term investors

Answer 8

Short term: an investor who needs money in short term would prefer to purchase a short term bond; would be subject to interest rate risk if purchased long term

Long term: investor who needs money in long term would prefer a long term bond; would be subject to reinvestment risk if purchased short term

Question 9

Liquidity Preference Theory

Answer 9

the shape of the yield curve will be influenced by the proportions of the different term investors

• if short term investors dominate the market, forward rates will exceed expected spot rate, which will produce rising yield curve
• if long term investors dominate, forward rates will be lower than expected short rates

forward rates should be > expected future spot rates

Question 10

Bond investors are dominantly short-term; to attract them to hold long-term bond

Answer 10

the yield rate must be higher. This implies that forward rate must be higher than the expected short rate in the future.

Question 11

if downward sloping

Answer 11

short rates must be expected to decrease even more than under expectations hypothesis because risk premium exits for longer maturities and long term bonds have a greater amount of demand related to supply than short term

Question 12

despite fact that yield curve is affected by other factors like liquidity premium

Answer 12

it can still provide signs about future business cycle

• if curve has a steep positive rise, it is still likely that the market expects an expansion in economic activity
• if curve is sloping downward, it is likely that interest rates are expected to decline

Question 13

On-the-run yield curve

Answer 13

This plots the yield as a function of recently issued coupon bonds selling at or near par value

Question 14

investors tend to choose

Answer 14

shorter term investments if yield is the same as longer term yield

Question 15

borrowers prefer

Answer 15

longer term if yields are the same

Question 16

bank is at risk if

Answer 16

depositors will always choose to deposit at short term rate and loan buyers will always lock in long term rate

-risk if interest rates rise significantly, depositors will demand higher rate once term ends but loans will be locked in for several more years