Michaelmas Term - Lecture 7 Flashcards
What is the yield to maturity?
The yield to maturity is the discount rate that makes the PV = 0. It is the bond’s IRR.
What explains upwards and downwards sloping term structures?
Expectations hypothesis. If investors expect spot rates to increase in the long run then the term structure will be upward sloping. If they expect the spot rates to decrease in the long run the the term structure will be downward sloping.
Which two hypotheses explain what he term structure exists?
1) Liquidity premium hypothesis - Lenders prefer liquidity (short-term), borrowers prefer long-term so the market provides a term premium
2) Segmentation hypothesis - Ever maturity has its own clientele
What is the duration of a bond?
The elasticity of its price with respect to changes in yields. It is the % change in price associated with a 1% change in yield.
What is the modified duration?
The percentage change in the price of a bond in response to a percentage change in yield
What is the duration of a zero coupon bond?
The duration is equal to is maturity
What are immunisation strategies?
These are strategies used by financial institutions to shield their financial status from exposure to interest rate fluctuations.
These strategies are dynamic and must be revised at future dates as durations change over time.
Name some issues with immunisation.
1) Requires rebalancing after yields change
2) Rebalancing may be expensive so some duration mismatches may have to be tolerated
3) Immunisation with duration is only useful for small yield changes
Why is immunisation with duration only useful for small yield changes?
This is because we get a linear approximation to bond prices as yields change when we use durations only. We can introduce convexity to predict more accurate changes.
What is indexing and how are indexes formed?
This is where you construct a portfolio whose returns over time replicate the returns of a bond index.
This can be done by using all the bonds in the original index but this can be costly. One way of sampling is via cell matching strategy. This is where the original index is decomposed into cells based on characteristics and these cells have bonds that match allocated to them.
What is an active investment strategy?
An active investment strategy is a strategy that try to earn returns that are greater than these commensurate with the risk. This can only be done if you have information that is superior to that of the market (under EMH).
