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Fixed Income L2 > The Term Structure & Interest Rate Dynamics > Flashcards

The Term Structure & Interest Rate Dynamics Flashcards

1
Q

What is formula for discount factor at maturity?

A

DFn = (1 / (1+ Zn)^n)

DFn = discount factor at maturity
Zn = yield to maturity of a single payment is called spot rate

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2
Q

What does the spot rate represent?

A
  • represents the annualized return on a zero-coupon bond that has no default risk and no embedded options
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3
Q

What are forward rates?

A
  • Forward rates are interest rates that can be determined today but apply to future time periods
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4
Q

What is term structure?

A
  • interest rates of similar quality bonds at different maturities
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5
Q

What does a forward rate for a deposit that will be made at time A and mature at time B be denoted as?

A

Fa,b-a

example, an investor who will make a 3-year deposit in two years will earn a rate of F2,3 and collect the proceeds five years from today.

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6
Q

What is the forward pricing model?

A
  • forward pricing model is based on the no-arbitrage principle, an investor who makes a 5-year risk-free deposit today should earn the same return as an investor who makes a one-year risk-free deposit today and then rolls the proceeds over at maturity into a 4-year risk-free deposit.
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7
Q

What are the 2 formulas that explain the relationship between discount factors and the forward rate formula?

A

DFb = DFa * Fa, b-a which is equivalent to Fa, b-a = (DFb / DFa)

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8
Q

What is formula for forward price model using forward rate?

A

Fa, b-a = (1 / (1+fa, b-a)^ b-a)

Fa, b-a = forward price model
fa, b-a = forward rate model

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9
Q

What is formula to find forward rate derived from the spot rate?

A

(1+ zb)^b = ((1+za)^a) * ((1+ fa, b-a)^b-a)

fa, b-a = forward rate
zb = spot rate at time B
za = spot rate at time A

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10
Q

What is formula for the T - year spot rate?

A

((1+ zt)^t) = (1+z1) * (1+f1,1) * (1+f2,1) * (1+f3,1)

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11
Q

When does the spot curve lie above the forward curve or below the forward curve?

A
  • spot curve will lie above forward curve when spot curve is downward sloping
  • spot curve will lie below forward curve when spot curve is upward sloping
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12
Q

What is the par curve?

A
  • par curve represents the yield to maturity on similar coupon-paying government bonds priced at par.
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13
Q

What is yield to maturity and when will I be investor earn yield to maturity?

A
  • YTM is rate of return that investors expect to earn from holding it if 3 conditions are met
  • bond is held to maturity.
  • all coupon and principal payments are made on time and in full.
  • all cash flows are reinvested at the original YTM.
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14
Q

What is riding the yield curve strategy (aka rolling down the yield curve)?

A
  • a trading strategy that involves buying a long-term bond and selling it before it matures so as to profit from the declining yield that occurs over the life of a bond.
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15
Q

What is carry trade trading strategy?

A
  • trading strategy that involves borrowing at a low-interest rate and re-investing in a currency or financial product with a higher rate of return
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16
Q

What are swaps?

A
  • Swaps: derivative contracts that typically exchange fixed-rate interest payments for floating-rate interest payments
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17
Q

What is the swap rate and what is it denoted as?

A
  • fixed-rate leg of an interest rate swap is called the swap rate and is denoted as sT
18
Q

At inception what is the swap rate set to?

A
  • swap rate is set so the swap value is zero at inception
19
Q

What is the swap spread?

A
  • swap spread is the swap rate less the on-the-run government security with the same maturity. It indicates credit spreads and liquidity spreads in a market
20
Q

What is the I-spread?

A
  • I-spread (interpolated spread): which measures the difference between a bond’s yield and the swap rate for the same maturity.
21
Q

What is the z spread?

A
  • a constant basis point spread that is added to the implied spot yield curve in order to ensure that discounted future cash flows are equal to the current market price. more accurate measure of credit and liquidity
22
Q

What is the TED spread?

A
  • TED spread (i.e., Treasury-Eurodollar spread): Libor minus the yield on a T-bill of matching maturity. indicator of perceived credit risk in the economy, an increase means increased risk of default on interbank loans
23
Q

What is the Libor-OIS spread?

A
  • Libor-OIS spread is the difference between Libor and the overnight indexed swap (OIS) rate. indicates the risk and liquidity of money market securities.
24
Q

What is the unbiased expectations theory (aka pure expectations theory)?

A

-unbiased expectations theory states that if there are two investors, one invests in two consecutive one-year bonds and the other invests in a single two-year bond, in the end, the return will be the same for both investors.

25
Q

What is the local expectations theory?

A
  • Local Expectations Theory: theory that suggests that the returns of bonds with different maturities should be the same over the short-term investment horizon
26
Q

What is the liquidity preference theory?

A
  • liquidity preference theory: assumes that investors expect additional compensation for the interest rate risk associated with lending over longer periods.
27
Q

What is the segmented markets theory?

A
  • segmented markets theory: assumes that the shape of the yield curve is influenced by the preferences of lenders and borrowers. The yield curve is a function of supply and demand at different maturities. If demand is particularly high for bonds with a certain range of maturities, yields in that segment of the curve will be lower.
28
Q

What is the preferred habitat theory?

A
  • preferred habitat theory: investors generally prefer short-term bonds but may opt for long-term ones if they offer higher yields and suitable risk premiums.
  • preferred habitat theory allows for the possibility that investors can be induced to leave their preferred segment of the market if the compensation is sufficient.
29
Q

What is the preferred habitat theory?

A
  • preferred habitat theory: investors generally prefer short-term bonds but may opt for long-term ones if they offer higher yields and suitable risk premiums.
  • preferred habitat theory allows for the possibility that investors can be induced to leave their preferred segment of the market if the compensation is sufficient.
30
Q

What is shaping risk?

A
  • Shaping risk: sensitivity of a bond’s price to the changing shape of the yield curve
31
Q

What are 3 factors affecting the shape of a yield curve?

A
  • Level
  • Steepness
  • Curvature
32
Q

What is yield curve risk?

A
  • bond portfolio exposure to shifts in the yield curve
33
Q

Describe the 3 factors affecting the shape of a yield curve?

A
  • Level: parallel up or down shift in yield curve (eg. level coefficient of -0.5 indicates that the bond’s price will fall by 0.5% in response to an increase of one standard deviation in the level of the yield curve.)
  • Steepness: non parallel shift in yield curve (e.g., short-term rates increase by more than long-term rates)
  • Curvature: twists in the yield curve (e.g., short-term rates increase while long-term rates fall)
34
Q

Why is the volatility curve for bonds with embedded options usually downward slopping?

A
  • downward sloping because short-term rates tend to be more volatile while longer-term rates are relatively stable.
35
Q

What is the difference between effective duration and key rate duration?

A
  • effective duration: measure bond price sensitivity to small parallel shift in benchmark yield curve
  • key rate duration: measure sensitivity of a security or value of portfolio to a 1% change in yield for a given maturity
36
Q

What is formula for change in value of portfolio that accounts for change in 3 factors of a yield curve?

A

change in value of portfolio = (-Dl * r) - (-Ds * r) - (-Dc * r)

Dl = levelness
Ds = steepness
Dc = curvature
r = yield change

37
Q

What rates are primarily influenced by monetary policy and what rates are primarily influenced by inflation?

A
  • short term/ intermediate term rates are primarily influenced by monetary policy
  • long term rates are primarily influenced by inflation
38
Q

How does fiscal policy, maturity structure, and investor demand impact bond yields?

A
  • fiscal policy: yields rise as governments issue more debt to finance their budget deficits. restrictive fiscal policy will reduce the supply of new government debt, causing investors to lower their required returns
  • maturity structure: relative increase in the supply of longer-dated government bonds increases yields and excess returns in this segment of the market
  • investor demand: greater demand will put downward pressure on yields, driving up bond prices.
39
Q

What is the bond risk premium?

A
  • bond risk premium: yield required to hold a long-term default-free bond in excess of the short-term risk-free rate.
40
Q

What is a bullish steepening?

A
  • bullish steepening: (eg. short-term rates falling faster than long-term rates) is typically observed when a central bank loosens monetary policy in an effort to stimulate an economy that is operating below its potential
41
Q

What is the difference between bearish flattening and bullish flattening?

A
  • bearish flattening: short-term rates increasing more than long-term rates
  • bullish flattening: also called flight to quality indicates that long term interest rates are falling, implying lower inflation in the future, which is good for the economy
42
Q

What is the difference between bullet portfolio and barbell portfolio?

A
  • bullet portfolio: concentrated on single maturity
  • barbell portfolio: combination of short and long dated bonds

Fixed Income L2 (2 decks)

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