IPT 1 Chapter 15

Question 1

What is the term structure of interest rates?

Answer 1

Fact 1: Interest rates typically co-move
Fact 2: Most of the time, yield curves are upward sloping
Fact 3: When short-term interest rates are low, yield curve is typically upward sloping, but when they are high, yield curve can be flat, downward sloping or kinked
Fact 4: Short-term interest rates are much more volatile than long-term rates

Question 2

What is the spot rate?

Answer 2

Yield to maturity on zero-coupon bonds

Question 3

What is the short rate?

Answer 3

Interest rate available at different points in time

Question 4

What theories try to explain yield curves?

Answer 4

1. Expectations Theory
2. Market Segmentation theory
3. Liquidity Premium Theory

Question 5

What does the Expectations theory argue, and the key assumption?

Answer 5

Interest rates will average of short and long term rates based on expectations

Key assumption: Investors do not have inherent preferences over bond maturities

Question 6

What does the Expectation theory state>

Answer 6

The forward rate equals the market expectation of the future short interest rate

Question 7

Can all facts be explained with the Expectations theory?>

Answer 7

Fact 1, Yes, serial correlation
Fact 2: No, only if interest rates are expected to be higher in the future its upward sloping
Fact 3: Yes, if interest rates are in expectation mean-reverting
Fact 4: Yes, averages from larger samples are less volatile

Question 8

What is the Market Segmentation theory, and the key assumption?

Answer 8

Bonds with different maturities have completely different markets and solely depend on the supply and demand in each of those seperate markets

Key assumption:
Investors have strong preferences over maturities and are no substitutes

Question 9

Can all facts be explained with the Market segmentation theory?

Answer 9

Fact 1, No, seperate markets seperate demand and supply
Fact 2: Yes, Long term bonds carry more risk and thus carry more interest
Fact 3: No, since there are seperate markets
Fact 4: No, Short-term bonds carry less interest rate risk

Question 10

What is the Liquidity Premium theory and its key assumption?

Answer 10

Interest rate on long term bond equal an average of short-term interest rates expected over the life time plus an liquidity premium

Key assumption:
Maturities matter but not at any cost
Same bonds with different maturities are imperfect substitutes

Question 11

Can all facts be explained with liquidity premium theory?

Answer 11

Fact 1: Yes, short term rates expected change and so do longer term rates expectations
Fact 2: Yes, due to liquidity premium increasing with maturity
Fact 3: Yes, if interest rates are mean-reverting
Fact 4: Yes, averages of larger samples are less volatile