week 3a

Question 2

the yield curve

Answer 2

The yield curve is the graphic representation of the relationship between the yield
of bonds of the same credit quality but different maturity

Question 3

Why has the Treasury market historically been used to construct the yield curve?

Answer 3

1) Treasury securities are considered free of default risk, making them suitable for estimating yields across different maturities, and 2) the Treasury market is highly liquid, providing reliable data for yield estimates.

Question 4

What are the limitations of using the Treasury yield curve?

Answer 4

The traditionally constructed Treasury yield curve may not accurately reflect the relationship between required yield and maturity for all bonds. It may not account for factors such as differences in credit quality and liquidity that affect yields on other types of bonds.

Question 5

How is the price of a bond determined?

Answer 5

The price of a bond is calculated as the present value of its expected cash flows. This involves discounting future cash flows by an appropriate interest rate.

Question 6

What is the appropriate interest rate used to discount the cash flows of a bond?

Answer 6

The appropriate interest rate is typically the yield on a Treasury security with the same maturity as the bond, adjusted for any additional risk premium or spread associated with the bond.

Question 7

What is the problem with using the Treasury yield curve to determine the appropriate yield for discounting bond cash flows?

Answer 7

One challenge with using the Treasury yield curve is that it may not accurately reflect the risk characteristics of other types of bonds. This can lead to mispricing if the risk premium or spread is not properly accounted for.

Question 8

What is the first fact that the theory of the term structure of interest rates must explain?

Answer 8

Interest rates on bonds of different maturities tend to move together over time. This implies a relationship between short-term and long-term interest rates.

Question 9

What is the second fact that the theory of the term structure of interest rates must explain?

Answer 9

When short-term interest rates are low, yield curves are more likely to have an upward slope; conversely, when short-term rates are high, yield curves are more likely to slope downward and be inverted. This phenomenon is known as the yield curve’s behavior in different interest rate environments

Question 10

What is the third fact that the theory of the term structure of interest rates must explain?

Answer 10

Yield curves almost always slope upward. This means that longer-term bonds typically offer higher yields than shorter-term bonds, a pattern that needs to be accounted for in any theory of the term structure of interest rates.

Question 11

What shape is the yield curve when the economy is in a healthy position

Answer 11

upward sloping

Question 12

what shape is the yield curve when the economy is not doing well

Answer 12

downward sloping or flat

Question 13

why may the yield curve be downward sloping

Answer 13

there many be a recession as the short term bonds have higher yields than long term
investors are expecting economic growth to slow down and hence interest rates will decrease and their will be a higher demand for higher yielding maturity which drives the yield curve down

Question 14

why may the yield curve be flat

Answer 14

don’t translate to action of buying and selling it is usually the transition

Question 15

what are the determinants of the shape of the structure

Answer 15

• the expectations theory
• the liquidity theory
• the preferred -habitat theory
• the market segmentation theory

Question 16

How does the Pure Expectations Theory explain the behavior of market participants when expecting rising short-term rates?

Answer 16

when economic news leads market participants to expect short-term interest rates to rise in the future, several actions occur:

Question 17

According to the pure expectation theory what do long term investors do

Answer 17

Investors interested in long-term investments would avoid buying long-term bonds because they anticipate a decline in bond prices as rates rise. They may prefer to wait until rates increase to purchase bonds at higher yields.

Question 18

According to the pure expectation theory what do speculators do

Answer 18

Speculators anticipating rising rates would expect a decline in the price of long-term bonds. Consequently, they would want to sell any long-term bonds they currently own to avoid losses from falling bond prices.

Question 19

According to the pure expectation theory what do borrowers do

Answer 19

Borrowers seeking long-term funds may be incentivized to borrow now rather than later. They anticipate that rates will rise in the future, making borrowing costs higher.

Question 20

What is interest-rate risk, and why does it arise?

Answer 20

Interest-rate risk arises from the mismatch between an investor’s investment horizon and a bond’s time to maturity. If a bondholder plans to sell a bond before it matures, changes in interest rates can lead to capital gains or losses. The longer the term of the bond, the greater the potential for price changes and capital losses due to interest rate fluctuations.

Question 21

What is the Liquidity Premium Theory?

Answer 21

investors require compensation for the increased risk associated with buying longer-term bonds. It suggests that bond yields consist of two components: one representing the risk-free rate (explained by the Expectations Theory) and another representing the risk premium (explained by inflation and interest-rate risk).

Question 22

How is the Liquidity Premium Theory incorporated into the term structure equation?

Answer 22

The Liquidity Premium Theory adds the risk premium (lnt) to the equation derived from the Expectations Theory. This equation accounts for both the risk-free component (i1t) and the additional compensation for risk (lnt) associated with longer-term bonds.

Question 23

according to the preferred habit theory what are investors bond preferences

Answer 23

investors have a preference for bonds of one maturity over another and will only be willing to buy bonds of different maturities if they can earn a higher expected return. Additionally, investors are likely to prefer short-term bonds over longer-term bonds.

Question 24

according to segmented market theory, are bonds of different maturities considered substitutes?

Answer 24

No, bonds of different maturities are not substitutes at all.

Question 25

according to segmented market theoryHow are interest rates for bonds with different maturities determined?

Answer 25

The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond.

Question 26

Do investors have preferences for bonds of one maturity over another?

Answer 26

Yes, investors have preferences for bonds of one maturity over another.

Question 27

How does investors’ preference for bonds with shorter maturities explain the typical upward slope of yield curves?

Answer 27

If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this preference explains why yield curves usually slope upward according to the segmented market theory