Fixed Income Flashcards
Expectations Theory
The three forms of the expectations theory (the pure expectations theory, the liquidity preference theory, and the preferred habitat theory) assume that the forward rates in current long-term bonds are closely related to the market’s expectations about future short term rates. The three forms of the expectations theory differ on whether or not other factors also affect forward rates, and how.
Pure Expectations Theory
The pure expectations theory postulates that no systematic factors other than expected future short-term rates affect forward rates. According to the pure expectation theory, forward rates exclusively represent expected future spot rates. Thus, the entire term structure at a given time reflects the market’s current expectations of the family of future short-term rates. A rising term structure must indicate that the market expects short-term rates to rise throughout the relevant future. A flat term structure reflects an expectation that future short-term rates will be mostly constant. A falling term structure must reflect an expectation that future short-term rates will decline. Because forward rates are not perfect predictors of future interest rates, the pure expectations theory neglects the risks (interest rate risk and reinvestment risk) associated with investing in Treasury securities.Advocates of the pure expectations theory argue that forward rates are the market’s consensus of future interest rates. Forward rates have not been found to be good predictors of future interest rates; however, an understanding of forward rates is still extremely important because of their role as break-even rates and rates that can be locked in.
Liquidity Preference Theory
The liquidity preference theory and the preferred habitat theory assert that there are other factors that affect forward rates and these two theories are therefore referred to as biased expectations theories. The liquidity preference theory states that investors will hold longer-term maturities only if they are offered a risk premium and therefore forward rates should reflect both interest rate expectations and a liquidity risk premium. According to the liquidity preference theory, forward rates will not be an unbiased estimate of the market’s expectations of future interest rates because they contain a liquidity premium. Thus, an upward-sloping yield curve may reflect expectations that future interest rates will 1) either rise 2)or be unchanged or even fall. But with a liquidity premium increasing fast enough with maturity so as to produce an upward-sloping yield curve. Any shape for either the yield curve or the term structure of interests rates can be explained by pure expectation and liquidity preference theory jointly. Not by liquidity preference theory individually
Preferred Habitat Theory
The preferred habitat theory, in addition to adopting the view that forward rates reflect the expectation of the future path of interest rates as well as a risk premium, argues that the yield premium need not reflect a liquidity risk but instead reflects the demand and supply of funds in a given maturity range. If there is an imbalance between the supply and demand for funds within a given maturity range, investors and borrowers will shift their investing and financing activities out of their preferred maturity sector to take advantage of any imbalance
Gap Analysis
A traditional measure of interest risk is the maturity gap between assets and liabilities, which is based on the repricing interval of each component of the balance sheet. To compute the maturity gap, the assets and liabilities must be grouped according to their repricing intervals. Within each category, the gap is then expressed as the rand amount of assets minus those of liabilities. Altough the maturity gap suggests how a bank’s condition will respond to a given change in interest rate, and thus permits the analyst to get a quick and simple overview of the profile of exposure, the downside of this approach is that it doesn’t offer a single summary statistic that expresses the bank’s interest rate risk. It also omits some important factors, for example, cash flows, unequal interest rates on assets and liabilities, and initial net worth.
Gap Analysis
A traditional measure of interest risk is the maturity gap between assets and liabilities, which is based on the repricing interval of each component of the balance sheet. To compute the maturity gap, the assets and liabilities must be grouped according to their repricing intervals. Within each category, the gap is then expressed as the rand amount of assets minus those of liabilities. Altough the maturity gap suggests how a bank’s condition will respond to a given change in interest rate, and thus permits the analyst to get a quick and simple overview of the profile of exposure, the downside of this approach is that it doesn’t offer a single summary statistic that expresses the bank’s interest rate risk. It also omits some important factors, for example, cash flows, unequal interest rates on assets and liabilities, and initial net worth.
Duration analysis
Duration can also be used and is usually presented as an account’s weighted average time to repricing, where the weights are discounted components of cash flow. A bank will be perfectly hedged when the duration of its assets, weighted by rands of assets, equals to the durations is called the duration gap, and the larger the bank’s duration gap is, the more sensitive a bank’s net worth will be to a given change in interest rates. The advantages of duration analysis is that it proviedes a simple and accurate basis for hedging portfolios, it can be used as a standard of compariosn for business development and funding strategies, and it provides the essential elemets for the calculation of interest rate elasticity and price elasticity. Several technical factors however, make it difficult to apply duration analysis correctly. First, the detailed information on cash flows required for duration analysis presents a computation and accounting burden. Second, the true cash flow patterns are not well known for certain types of accounts, such as demand deposits, and they arel ikely to vary withthe size or timing of a change in market interest rates, making it harder to quantify the associated interest rate risk. Finally, a more complex version of duration is needed to reflect the fact that, long-term interest rates are not always equal to short-term interest rates and may move independetly from each other.
Duration analysis
Duration can also be used and is usually presented as an account’s weighted average time to repricing, where the weights are discounted components of cash flow. A bank will be perfectly hedged when the duration of its assets, weighted by rands of assets, equals to the durations is called the duration gap, and the larger the bank’s duration gap is, the more sensitive a bank’s net worth will be to a given change in interest rates. The advantages of duration analysis is that it provides a simple and accurate basis for hedging portfolios, it can be used as a standard of comparison for business development and funding strategies, and it provides the essential elements for the calculation of interest rate elasticity and price elasticity. Several technical factors however, make it difficult to apply duration analysis correctly. First, the detailed information on cash flows required for duration analysis presents a computation and accounting burden. Second, the true cash flow patterns are not well known for certain types of accounts, such as demand deposits, and they are likely to vary with the size or timing of a change in market interest rates, making it harder to quantify the associated interest rate risk. Finally, a more complex version of duration is needed to reflect the fact that, long-term interest rates are not always equal to short-term interest rates and may move independently from each other.
Simulation analysis
Some banks simulate the impact of various risk scenarios on their portfolios (Schaffer, 1991). In other words, simulation analysis involves the modelling of changes in the bank’s profitability and value under alternative interest rate scenarios (Payne et al., 1999). The advantages of this technique are that it permits an easy examination of a bank’s interest rate sensitivities and strategies (Cade, 1997), and it replicates the same bottom line as duration theory while bypassing the more sophisticated mathematical deviations. The drawback of this approach is that the need for detailed cash flow data for assets and liabilities are not satisfied and computers alone cannot solve the problem of forecasting cash-flow patterns for some assets and liabilities (Shaffer, 1991).
Scenario analysis
Another approach is to choose interest rate scenarios within which to explore portfolio effects (Schaffer, 1991). Different scenarios must thus be set out and it must be investigated what the bank stand to loose or gain under each of them. Advantages of this approach are that it can be applied to most kinds of risks and that it is less limited by data availability. Schaffer (1991) states that this approach is thus more flexible and it requires less effort. Unfortunately traditional measures of interest rate risk, while convenient, provide only rough approximations at best (Shaffer, 1991) and derivatives must be used in addition.
Cash flow hedge:
This is a hedge against forecasted transactions or the variability in the cash flow of a recognized asset or liability (Landsberg, 2002, p. 11). In this hedge, a variable rate loan can, for example, be converted to a fixed rate loan. It can also hedge the cash flows from returns on securities to be purchased in the future, the cash flow from the future sale of securities, or the cash flow of interest received on an existing loan (Rasch & Colquitt, 1998).
Market value hedge
This is a hedge against exposure to changes in the value of a recognized asset or liability (Landsberg, 2002). In this type of hedge a fixed-rate can, for example, be converted to a variable rate (Rasch & Colquitt, 1998).
Foreign currency hedge:
A forward contract entered into to sell the foreign currency of the foreign operation would, for example, hedge the net investment. Therefore, if the exchange rate decreases, the net investment would also decrease. The forward contract would however increase in value because the currency could be purchased at a lesser amount than the locked-in selling price (Jones et al., 2000).
Other ways to manage interest rate risks.
x Forward contract: This is a legal agreement between two parties to purchase or sell a specific quantity of a commodity, government security or foreign currency or other financial instrument at a price specified now, with delivery and settlement at a specified future date. x Futures contract: This is an agreement to buy and sell a standard quantity and quality of a commodity, financial instrument, or index at a specified future date and price. x Interest rate swap: This is an agreement between two parties to exchange interest payments on a specified principal amount for a specified period. x Option: This is a contract conveying the right, but not the obligation to buy or sell a specified item at a fixed price within a specified period. The buyer of the option pays a non-refundable fee, called a premium, to the writer of the option and the maximum loss is the premium paid for the option. Options can be divided into caps, collars and floors:
DEFINITION OF ‘TERM STRUCTURE OF INTEREST RATES’
The relationship between interest rates or bond yields and different terms or maturities. The term structure of interest rates is also known as a yield curve and it plays a central role in an economy. The term structure reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions. In general terms, yields increase in line with maturity, giving rise to an upward sloping yield curve or a “normal yield curve.” One basic explanation for this phenomenon is that lenders demand higher interest rates for longer-term loans as compensation for the greater risk associated with them, in comparison to short-term loans. Occasionally, long-term yields may fall below short-term yields, creating an “inverted yield curve” that is generally regarded as a harbinger of recession.
General Formulas for Forward Rates
