Chapter 13: Term structure of interest rates

Question 1

What are the limitations of immunisation theory

Answer 1

• The theory relies on small changes in interest rates, the fund might not be protected against large changes in interest rates.
• Once interest rates move away from the initial interest rate, it may be necessary to rebalance the portfolio, this makes practical applications difficult even in the most simple of cases.
• There might not be an asset available to match the volatility of liabilities.
• There may be uncertainties around the assets and/or liabilities, making cashflows approximate rather than exact.
• Immunisation removes the likelihood of making large profits.

Question 2

n-year par yield

Answer 2

The coupon per R1 nominal that would be payable on a bond with term n year which would give the bond a current price under the current term structure of R1 per R1 nominal. Assuming the bond is redeemed at par.

Question 3

Law of one price

Answer 3

In an arbitage free market, if two investments provide the same cashflows in future, then they must have the same price