Week 7 Interest Rates

Question 1

How are FI different from non-financial firms,

What is the impact of changes in interest rate on longer dated investments compared to shorter dated investments

Answer 1

FIs are different from other Non-financial firms because both sides of a FI’s balance sheet are sensitive to movements in interest rates.

Value of longer dated investment instruments => more sensitive to i-rate movements than ST maturity investments

i-rate changes lead to changes in value of both assets &
liabilities => value of FIs.

Question 2

Generally what are the assets and Liabilities of a financial institution

Answer 2

Assets = Loans => interest received from borrowers

Liabilities = deposits and debt securities => interest paid on borrowed funds

Question 3

What is the term structure of interest rates and how can this be represented graphically

Answer 3

Term structure of interest rates = the relationship
between interest rates and the term to maturity.

This can be represented graphically with yeild on the y-axis and maturity on the x-axis

Question 4

What do the Forward rate serves as a benchmark rate

Answer 4

Forward rate serve as benchmark rate for identifying incorrectly priced fixed income securities and for setting the interest sensitivity of a bank’s balance sheet

Question 5

How is the forward rate calculated

Answer 5

LOOK AT EQUATIONS IN BTP FOLDER for instruction

Question 6

Explain the pure or unbiased expectation theory

Answer 6

It suggests that the shape of the yield curve is determined
by investors’ expectations of future interest rates (ie,
short-term rates over the period of competing long-term
securities)

When yield curve is upward-sloping, investors expect interest rates to rise.

Downward-sloping: interest rates fall

Flat: no change in interest rates

Question 7

What are the implication of the pure or unbiased expectation theory

Answer 7

Observed long term rate is a function of today’s short
term rate and expected future short-term rates

Long-term and short-term securities are perfect substitutes

Forward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rates.

Able to explain upward and downward sloping curves

Question 8

Explain Liquidity or Risk Premium preference of term structure

Answer 8

Need to pay a premium to get investors to provide money for longer periods as long-term bonds are more risky investors will demand higher premium

The yield curve has an upward bias over expectations built into the long term rates because of the risk premium

Question 9

What are the implication of Liquidity or Risk Preference term structure

Answer 9

The implicit forward rate is not necessarily equal to the
expected future short term rate.

Unable to explain downward sloping yield curve

Question 10

Explain Market Segmentation theory of term structure

Answer 10

Segmentation

The market for funds is viewed as a set of markets not a
single market

ST-mkt can be viewed as a liquidity adjustment mkt

LT-mkt can be for capital investment funds

Question 11

What are the implication of Market Segmentation Theory of term structure

Answer 11

Short rate is not related to the long rate in any direct manner as these rates are assumed set in different markets
subject to different supply and demand effects.

The implicit forward rate is not necessarily equal to the
expected spot rate.

Hence, the yield curve may possess little predictive power
as expected short rates may not exhibit the close r/ship
with long rates suggested by expectation theory

Question 12

Explain the Preferred Habitat theory of term structure

Answer 12

Extends the segmentation theory and explains why discontinuities in the yield curve are not observed

Premium (PR) is required to attract investors away from their preferred investment term.

The Implicit forward rate s no necessarily equal to the expected spot rate

Question 13

Define the standard definition of the bonds

Answer 13

A financial claim by which the issuer, or the borrower is
committed to paying back to the bondholder, or the lender, the cash amount borrowed, called principal, plus periodic
interests, called coupon, calculated on this amount during a given period of time

Question 14

Basic of Bonds

Q1. What does the following imply

a. Coupon > Yield
b. Coupon = Yield
c. Coupon

Answer 14

Q1.
A Price > Face value = sells at premium

Price = Face value = sells at par

Price

Question 15

What are the 3 measurements of interest Rate sensitivity

Answer 15

Duration

Gap Analysis

Sensitivity Analysis

Question 16

Define Duration of a bond

Answer 16

Duration is a measure for judging sensitivity of an asset’s price to changes in the overall level of interest rates

Defined as the weighted average time to receipt of a security’s cash flows, where the weights are the present value of the cash flow at each time relative to total present value

Useful way of thinking about duration is that it measures the average time to receipt of the bond’s cash flows

It weighs the cash flows according to their payment schedule giving a weighted average time for cash receipts the closer that figure is to the maturity of the asset, the more sensitive it is to interest rate changes

Question 17

Which bonds are most effected through the duration

Answer 17

The bond which will be affected the most is a zero coupon bond a bond that has only a single payment at maturity. The cash flow are received later than a regular bond with has some cash flows during the life of the bond

The higher the duration the more affected it becomes if there is a change in interest rates

Question 18

How is duration applied an what is the formula

Answer 18

We can use duration to make comparisons about the cash flow ad which are more affected by the changed in interest rates

The formula is in the BTP folder

The present value of the cashflows x period = The sum of this / Face value = 7.25

Question 19

Explain how Maturity Gap Measurement works and are used

Answer 19

Definition of maturity gap: Rate sensitive assets less rate sensitive liabilities

A FI will try to match the maturities and interest rates of assets and liabilities so that interest rate changes have less impact on overall profit

With i-rate gap analysis, we are interested in the impact of i-rate changes over some defined time horizon

Question 20

Explain the Simulation / Sensitive Analysis

Answer 20

Run a series of calculations representing the current situation and estimates of future interest rates from worst to best case scenario

Question 21

Explain how the calculation of simulation or sensitive analysis

Answer 21

For each item class multiply the assets and liabilities to obtain the revenue, expenses and net revenue. The sum across all item class is the net revenue of for the company.

If interest rate changes in each quarter multiply the assets and liabilities by the prevailing interest rate divided by the term 4 if its a quarter