Week 7 Interest Rates Flashcards
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
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.
Generally what are the assets and Liabilities of a financial institution
Assets = Loans => interest received from borrowers
Liabilities = deposits and debt securities => interest paid on borrowed funds
What is the term structure of interest rates and how can this be represented graphically
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
What do the Forward rate serves as a benchmark rate
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
How is the forward rate calculated
LOOK AT EQUATIONS IN BTP FOLDER for instruction
Explain the pure or unbiased expectation theory
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
What are the implication of the pure or unbiased expectation theory
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
Explain Liquidity or Risk Premium preference of term structure
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
What are the implication of Liquidity or Risk Preference term structure
The implicit forward rate is not necessarily equal to the
expected future short term rate.
Unable to explain downward sloping yield curve
Explain Market Segmentation theory of term structure
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
What are the implication of Market Segmentation Theory of term structure
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
Explain the Preferred Habitat theory of term structure
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
Define the standard definition of the bonds
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
Basic of Bonds
Q1. What does the following imply
a. Coupon > Yield
b. Coupon = Yield
c. Coupon
Q1.
A Price > Face value = sells at premium
Price = Face value = sells at par
Price
What are the 3 measurements of interest Rate sensitivity
Duration
Gap Analysis
Sensitivity Analysis
Define Duration of a bond
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
Which bonds are most effected through the duration
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
How is duration applied an what is the formula
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
Explain how Maturity Gap Measurement works and are used
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
Explain the Simulation / Sensitive Analysis
Run a series of calculations representing the current situation and estimates of future interest rates from worst to best case scenario
Explain how the calculation of simulation or sensitive analysis
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
