Chapter 11: Valuation of investments (1)

Question 1

Zero-coupon spot yield (or zero rate)

Answer 1

The zero-coupon spot yield is the (continuously-compounded) rate of return on a zero-coupon bond.

Question 2

Bond yield

Answer 2

the bond yield is the single interest rate such that the discounted present value of the payments on a bond is equal to the market value of the bond.

Question 3

Par yield

Answer 3

the par yield is the coupon rate that would be required to make the theoretical value of the bond equal to its nominal value under the prevailing pattern of zero-coupon interest rates.

Question 4

Forward interest rate

Answer 4

a forward interest rate is the interest rate implied by current zero-coupon rates for a specified future time period.

Question 5

Define a hedge

Answer 5

A hedge is defined as a trade to reduce risk

Question 6

Basis risk may arise if: (3)

Answer 6

1. The asset whose price is to be hedged is not exactly the same as the asset underlying the futures contract.
2. The hedger is uncertain as to the exact date when the asset will be bought or sold.
3. The hedge requires the futures contract to be closed out well before its expiration date.

Question 7

assumptions commonly used in asset models (3)

Answer 7

1. normality of increments in (log) asset prices
2. independence of increments in asset prices
3. constancy of parameters e.g. drift and volatility