New - Reading 42 - The Term Structure and Interest Rate Dynamics Flashcards

Question

What are the 4 different theories to explain the term structure of interest rates?

Answer 1

1. Local Expectations Theory 2. Liquidity Preference Theory 3. Segmented Markets Theory 4. Preferred Habitat Theory

Answer 2

That the forward rate is an unbiased predictor of the future spot rate

Answer 3

* Similar to the Pure Expectations Theory * Says that the expected return for every bond over the short term is the risk free rate \*\*In reality this doesn't hold perfectly. Short Holding Period Returns are often greater for long dated bonds than for shorter dated bonds.The need for liquidity and to hedge risk ensure that the demand for s/t bonds will exceed that for l/t bonds

Answer 4

Liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term and that these premiums increase with maturity

Answer 5

* allows for lender and borrower preferences to influence the shape of the yield curve * yields are solely a function of the supply and demand for funds of a particular maturity

Answer 6

* says that if the expected additional returns to be gained are large enough, institutions will be willing to deviate for their preferred maturities or habitats * ie... accept additional risk for expected additional return

Answer 7

1. Equilibrium Term Structure Models 2. Arbitrage Free Models

Answer 8

Models that seek to describe the dynamics of the term structure using fundamental economic variables that are assumed to affect interest rates

Answer 9

1. Cox-Ingersoll-Ross Model (**CIR**) 2. Vasicek Model

Answer 10

1. They are one factor or multi factor 2. They make assumptions about the behavior of factors 3. They are more sparing with respect to the # of parameters that must be estimated than other models

Answer 11

The Short Term Interest Rate

Answer 12

It assumes that every individual has to make consumption and investment decisions with their limited capital

Answer 13

dr = a(b-r)dt+σ√rdz \*\*is an instance of a so called continuous time finance model Breaks down into two parts 1. Drift Term 2. Random Part a= speed adjust to the long run value of the rate b = long run value of the short term rate r = current short term rate

Answer 14

dr = a(b-r)dt+σdz \*\*disadvantage is that it is theoretically possible for the interest rates to become negative\*\*

Answer 15

The underlying assumption is that the reference set is correctly priced b/c it uses observed market prices

Answer 16

Ho-Lee Model

Answer 17

* an arbitrage free model * used the relative valuation concept of Black Scholes option pricing model * assumes that the yield curve moves in a way that is consistent with a no arbitrage condition

Answer 18

The sensitivity of a bond's price to the changing shape of the yield curve

Answer 19

a model for description of yield curve movements that can be considered realistic when compared with historical data

Answer 20

1. **_Level_**- upward or downward shift to the yield curve 2. **_Steepness_**- a non-paralle shift in the yield curve 3. **_Curvature_**- movements of short, middle and long term segments

Answer 21

1. Duration 2. Key Rate Duration

Answer 22

To calculate this we need to remember we already have the P(1) and P(3) discount factors. P(1) = 0.9346 P(3) = 0.7722 Using the equation : P(T\*+T) = P(T\*) \* F(T\*,T) So 0.7722 = 0.9346 \* f(T\*,T) solve for f(T\*,T) = 0.7722 / 0.9346

Answer 23

So we are looking for f(1,1) (1+0.10)² = (1+0.09⁾¹ (1+f(1,1))¹ f(1,1) =[(1.1)² / 1.09] -1 = 11.01%

Answer 24

Using the Forward Rate Model were a solving the following: [1+r(2)]² = [1+r(1)]¹ \* [1+*f*(1,1)¹ [1+.05]² = [1+.04]¹ \*[1+*f*(1,1)] Solve for *f*(1,1)

Answer 25

C. When the expected spot rates are lower than the forward rate,the market is discounting the bond's payments at a higher rate than the investor and the bond's market price is lower than the intrinsic value perceived by the investor