New - Reading 42 - The Term Structure and Interest Rate Dynamics Flashcards
What does the notation P(T) represent?
The discount factor
What does the notation r(T) represent?
The spot rate
What is the equation to calculate the discount factor for a risk-free single unit payment?
What is a Forward Rate?
An interest rate that is determined today for a loan that will be initiated in a future time period.
What is the Forward Pricing Model and what is the equation to calculate it?
**using discount factors**
It describes the valuation of forward contracts
P(T*+T) = P(T*) x F(T*,T)
What is the no-arbitrage principle?
That tradable securities with identical cash flow payments must have the same price.
When the spot curve is upward(downward) sloppping, the forward curve will….
lie above(below) the spot curve
What does the Forward Rate Model tell us?
It shows how forward rates can be determined by using spot rates
What is the equation to use the Forward Rate Model?
**when using spot rates**
What does the notation f(7,1) mean?
The rate agreed to today for a 1 year loan starting in 7 years.
What are 2 ways Forward Rates can be viewed as?
- As a type of break even interest rate
- As a rate that can be locked in by extending maturity by 1 year
By re-arranging the Forward Rate Model, how can we calculate the forward rate?
What is the government par curve?
- Shows the yield to maturity on coupon paying gov’t bonds priced at par over a range of maturities
- It is important b/c it can be used to construct a zero coupon yield curve
Is the YTM the expected return of a bond?
NO
YTM = E(r) of a bond **only **if it is held to maturity, all coupon and principal payments are made _and _ all coupons can be invested at the original YTM
When can the YTM provide a poor estimate of the expected return?
**4 Reasons**
- Interest rates are volatile
- Yield curve is steeply sloped (can be upward or downward)
- There is significant risk of default
- The bond has one or more embedded option
How do active bond portfolio managers attempt to outperform the market?
By anticipating changes in interest rates relative to the projected spot rates reflected in today’s forward curve
What does it mean when a portfolio managers is “Rolling the Yield Curve” ??
**This is also known as “Riding the Yield Curve”
It is a trading strategy that involves buying bonds with a maturity longer than the intended investment horizon
In the forward rate model, what does T* stand for?
**Critical Concept**
The number of years until the loan begins
In the forward rate model, what does the term T stand for?
The length of the loan
What is a Swap Rate?
An interest rate for the fixed rate leg of an interest rate swap
What are 2 reasons why the Swap Market is so liquid?
- Significant flexibility & customization is available
- An efficient way to hedge interest rate risk