Fixed Structure of interest rates (yield curve)

Question 1

What are the three different shapes of the yield curve

Answer 1

Flat
Inverted (short-term yields, are higher than long-term yields)
Normal (long-term yields are higher than short-term)

Question 2

Why do you discount with the yield curve instead of a single yield?

Answer 2

Since bonds are not paid at the same time, each cash flow should be discounted at a unique rate appropriate for the
time period it will be received. This is why you can strip the bond into a basket of zero-coupon intruments where each instruments has maturity = coupon payment date

Question 3

What is the spot rate curve?

Answer 3

All of the yields of zero-coupon treasuries with the same maturity as your zero-coupon bonds

Question 4

How do you construct the theoretical spot rate curve?

Answer 4

Bootstrapping

Question 5

What is bootstrapping?

Answer 5

Transforming a coupon-yielding curve to a zero-coupon curve

Question 6

What are the 2 types of Interest rate swaps?

Answer 6

Changing from a fixed-rate loan for a floating-rate liability of a floating-rate loan to a fixed-rate liability

Question 7

Why are interest rate swaps used?

Answer 7

It can alter the interest rate risk of existing assets and liabilities.

Question 8

What is an interest rate swap (IRS)

Answer 8

An OTC contract to exchange a
* fixed periodic interest for a variable periodic interest
* in the same currency between two counterparties
* and according to a predetermined schedule

Question 9

What are the characteristics of an IRS?

Answer 9

• No exchange of nominal value at the beginning or at the end of the transaction
• The interest flows are calculated by applying a fixed rate on the one hand and a variable rate on the other hand on an identical nominal amount related to
  the number of days of the interest period
• The fixed rate is determined at the inception of the contract
• The level of the variable rate is determined at each interest period
• The payer of the fix leg is called the payer of the swap
• The payer of the floating leg is called the receiver of the swap

Question 10

When do you pay the swap?

Answer 10

When you pay floating and receive the fixed rate payment

Question 11

When do you receive the swap?

Answer 11

When you pay the fixed and receive the floating payment