The Term Structure and Interest Rate Dynamics - Reading 32 Flashcards
what is a spot rate
rate of interest on a security that makes a single payment at a future point in time
what is a forward rate
interest rate, set today, for a single-payment security to be issued at some point in time
What are the three conditions that make the E(r) equal to the bond’s yield?
- bond is held to maturity
- all payments are made on time and in full
- all coupons are reinvested at the original YTM
why YTM is a poor proxy for E(r)? (4 reasons)
- interest rates are volatile (reinvestment <> YTM)
- yield curve is stepped up or down (reinvestment <> YTM)
- significant risk of default (cash flows differ)
- embedded options (holding period may be different
What is the forward pricing model
J = loan starting in J years
K = number of years in the loan
“when,what”
P(J+K)=P(J)F(J,K)
How to calculate the forward rate model
[1+r(j+k)]^(j+k) = [1+r(j)]^(j) x [1+F(j,k)]^(k)
When the spot curve is upward sloping, where the forward curve will lie?
above
When the spot curve is downward sloping, where the forward curve will lie?
below
What is the strategy of riding the yield curve?
Consist on buying bonds with a maturity longer than the investment horizon, because it would provide a total return greater than the return on maturity-matching strategy but needs an upward sloping curve
What is TED Spread
amount by which the interest rate on loans between banks exceeds the interest rate on short-term US government debt (three month t bill)
A higher TED spread means that market participants believe banks are increasingly likely to default on loans and that risk free t-bills are become valuable in comparison
what is LIBOR-OIS Spread?/
reflects the federal; funds rate and includes minimal counterpart risk
Is an overall indicator of well being of the financial system
What is the unbiased expectations theory
Hypothesize that it is investors’ expectations that determine the shape of the interest rate term structure
This theory suggest that forward rates are solely a function of expected future spot rates, and that every maturity strategy has the same expected return over a given horizon. Long-term interest rates equal the mean of future expected short-term rates
What is the local expectations theory
Similar to the unbiased expectations theory, w/ one difference: the local expectation theory preserves the risk-neutrality assumption only for short holding periods and over longer periods, risk premium should exist.
This theory can be shown not to hold because short-holding-period returns of long-maturity bonds can be shown to be higher than short-holding-period returns on short-maturity bonds due to liquidity premiums and hedging concernings
What is the liquidity preference theory
The liquidity preference theory of the term structure
proposes that forward rates reflect investors’ expectations
of future spot rates plus a liquidity premium to compensate investors for exposure to interest rate risk
Also, suggest that this liquidity premium is positively related to maturity
What is the segmented markets
the segment market theory suggest that the yield at each maturity is determined independently of the yields at other maturities
