interest rates and shit Flashcards
The Yield Curve
plot of yield to maturity as a function of time to maturity
displays the relationship between YTM and time to maturity
Information on expected future short-term rates can be implied
are Yields on different maturity bonds equal?
no
Bond stripping and bond reconstitution may offer opportunities for what under Law of One Price?
for arbitrage
can bond coupon payments be seen as individual coupon bonds?
what does this mean for bond prices
yes
we need to discount every cash flow (bond and principal) at the appropriate discount rate corresponding to the maturity of this CF
Stripped bonds
zero-coupon bonds created by selling each coupon (or principal payment) made by the governments’ bond as a separate cash flow
how to determined the price of stripped bonds
To determine the price of its zero-coupon bonds we need to obtain their present value
There different yield curves used in the market
Pure yield curve
On-the-run yield curve
Pure yield curve
this is the yield curve for stripped or zero-coupon bonds
On-the-run yield curve
constructed from the YTM of different maturities recently issued coupon paying bonds
the Spot Rate
the yield to maturity on zero-coupon bonds
refers to the interest rate valid from today till the maturity of the corresponding zero-coupon bond
the geometric average of its component short rates
Short rate
refers to interest rate available for a specific time interval at a specific period of time
how to calculate short rate
r2 = (1 + y2) / (1 + r1) - 1
how to calculate the spot rate for two year holding period
y2 = ((1 + r1)(1 + r2))^(1/2)
A spot rate is the geometric average of its component short rates
why does the long term yield curve slope up
because of interest risk premium
when does the Yield curve slope up?
what could this indicate
When next year’s short rate, r2 > r1, the yield curve slopes up
May indicate rates are expected to rise
when does the Yield curve slope down?
what could this indicate
When next year’s short rate, r2 < r1, the yield curve slopes down
hot calculate a forward rate
(1 + fn) = ((1 + yn)^n) / (1 + yn-1)^(n-1)
what happens to the liquidity premiums when short rates and forward rates are expected to remain constant?
liquidity premiums remain constant
what happens to the liquidity premiums when short rates are expected to decline and forward rates are expected to increase?
liquidity premiums increases
what happens to the liquidity premiums when short rates and forward rates are expected to remain decrease at the same rate?
liquidity premiums remain constant
what happens to the liquidity premiums when short rates increase but forward rates are expected to remain increase even more at the same rate?
liquidity premiums increases
The expectations hypothesis
states that forward rates correspond to the future interest rates expected by the market
Observed long-term rate is a function of today’s short term rate and expected future short-term rates
fn = E(rn) such that liquidity premiums are zero
The liquidity preference hypothesis
states that the market is dominated by short term investors who require a premium to induce them to invest in longer term instruments instead of investing in short term ones
Longer term rates being larger than shorter term rates lead to?
having higher forward rates than spot rates
Long-term bonds are more risky: fn > E(rn)
The excess of fn over E(rn) is the liquidity premium
The yield curve has an upward bias built into the long-term rates because of the liquidity premium
what does an up sloping yield curve mean?
Rates are expected to rise
or
Investors require large liquidity premiums to hold long term bonds
how is the yield curve is a good predictor of the business cycle?
Long term rates tend to rise in anticipation of economic expansion
Inverted yield curve may indicate that interest rates are expected to fall and signal a recession
