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Questions and Answers
What does the term structure of interest rates refer to?
What does the term structure of interest rates refer to?
- Analysis of historical interest rate trends
- Graph of market expectations for future economic growth
- Relationship between the interest rates of different financial instruments with different maturities (correct)
- Comparison of interest rates across different bond types
In the term structure, why are shorter-term interest rates usually lower than longer-term interest rates?
In the term structure, why are shorter-term interest rates usually lower than longer-term interest rates?
- In response to short-term monetary policy changes
- Because of historical inflation trends
- Due to market expectations and economic growth (correct)
- Reflecting changes in global GDP growth
What do long-term bond yields reflect according to the text?
What do long-term bond yields reflect according to the text?
- Changes in GDP growth
- Global political stability
- Expectations of inflation rates (correct)
- Market liquidity conditions
What does a yield curve graph plot against the maturity of debt instruments?
What does a yield curve graph plot against the maturity of debt instruments?
Why is the term structure often considered synonymous with the yield curve?
Why is the term structure often considered synonymous with the yield curve?
What insight does the term structure provide about market participants?
What insight does the term structure provide about market participants?
How does tightening monetary policy affect short-term interest rates?
How does tightening monetary policy affect short-term interest rates?
What does a flat yield curve indicate?
What does a flat yield curve indicate?
According to the Liquidity Premium Theory, why are investors compensated with higher rates for holding long-term bonds?
According to the Liquidity Premium Theory, why are investors compensated with higher rates for holding long-term bonds?
During the Global Financial Crisis (GFC), what happened to the credit risk premium for banks?
During the Global Financial Crisis (GFC), what happened to the credit risk premium for banks?
What does the Liquidity Premium Theory state about the relationship between yield and term length?
What does the Liquidity Premium Theory state about the relationship between yield and term length?
For an investor with a short-term investment horizon, according to the theory, which type of bond would be preferred?
For an investor with a short-term investment horizon, according to the theory, which type of bond would be preferred?
How does the Liquidity Premium Theory impact the choice between different investment strategies?
How does the Liquidity Premium Theory impact the choice between different investment strategies?
What is one of the factors included in yield curves as per the Liquidity Premium Theory?
What is one of the factors included in yield curves as per the Liquidity Premium Theory?
What is the main implication of the Liquidity Premium Theory on longer-term securities?
What is the main implication of the Liquidity Premium Theory on longer-term securities?
What is the main difference between spot interest rates and forward interest rates?
What is the main difference between spot interest rates and forward interest rates?
How can forward interest rates help investors hedge against future interest rate risk?
How can forward interest rates help investors hedge against future interest rate risk?
What is the term of a spot rate based on?
What is the term of a spot rate based on?
Where are actual forwards discovered?
Where are actual forwards discovered?
What does a forward rate agreement involve?
What does a forward rate agreement involve?
Why are forward rates important for investors and traders?
Why are forward rates important for investors and traders?
What does the subscript represent in the term 'orn' for spot rates?
What does the subscript represent in the term 'orn' for spot rates?
What is the purpose of a spot rate in investments?
What is the purpose of a spot rate in investments?
What does the liquidity premium theory not explain about non-normal yield curves?
What does the liquidity premium theory not explain about non-normal yield curves?
What approach is consistent with variations in short term rates?
What approach is consistent with variations in short term rates?
What do forward rates reflect according to the text?
What do forward rates reflect according to the text?
Why do lenders and borrowers trade with each other in derivative markets?
Why do lenders and borrowers trade with each other in derivative markets?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What does a downward sloping Pales Diagram curve represent?
What does a downward sloping Pales Diagram curve represent?
What effect would lower-than-expected interest rates have on a company planning to issue money market securities?
What effect would lower-than-expected interest rates have on a company planning to issue money market securities?
What is the main advantage of using FRAs according to the text?
What is the main advantage of using FRAs according to the text?
What does the standard documentation for FRAs specify?
What does the standard documentation for FRAs specify?
In the FRA equation for cash settlement, what does $V_{ ext{market}}$ represent?
In the FRA equation for cash settlement, what does $V_{ ext{market}}$ represent?
Why do FRAs not have a secondary market, as mentioned in the text?
Why do FRAs not have a secondary market, as mentioned in the text?
What is the primary market for FRAs characterized by?
What is the primary market for FRAs characterized by?
How is the term of an FRA defined?
How is the term of an FRA defined?
What is a key feature of the settlement in an FRA agreement according to the text?
What is a key feature of the settlement in an FRA agreement according to the text?
Why are FRAs considered convenient to arrange based on the text?
Why are FRAs considered convenient to arrange based on the text?
What does a strip of FRAs hedge according to the text?
What does a strip of FRAs hedge according to the text?
Why should both methods of calculating 2 year rate or 1 year rate give the same answer according to the text?
Why should both methods of calculating 2 year rate or 1 year rate give the same answer according to the text?
What happens to bond yields when the coupon payments are stripped from the bonds?
What happens to bond yields when the coupon payments are stripped from the bonds?
In an inverted yield curve, what do investors expect about economic growth?
In an inverted yield curve, what do investors expect about economic growth?
If shorter interest rates are higher than longer-term rates, what type of yield curve shape is observed?
If shorter interest rates are higher than longer-term rates, what type of yield curve shape is observed?
What is the primary purpose of using the bootstrapping method in calculating forward interest rates?
What is the primary purpose of using the bootstrapping method in calculating forward interest rates?
What impact does a flat yield curve have on market instruments' rates?
What impact does a flat yield curve have on market instruments' rates?
What does the yield curve plot against the maturity of debt instruments?
What does the yield curve plot against the maturity of debt instruments?
How are shorter-term interest rates typically compared to longer-term interest rates in the term structure of interest rates?
How are shorter-term interest rates typically compared to longer-term interest rates in the term structure of interest rates?
What does the level of long-term bond yields in the term structure of interest rates reflect?
What does the level of long-term bond yields in the term structure of interest rates reflect?
Why is the term structure of interest rates important according to the text?
Why is the term structure of interest rates important according to the text?
What is a strip of FRAs used to hedge according to the text?
What is a strip of FRAs used to hedge according to the text?
What does the Liquidity Premium Theory state about the relationship between yield and term length?
What does the Liquidity Premium Theory state about the relationship between yield and term length?
What does the bootstrapping method involve in relation to bond stripping?
What does the bootstrapping method involve in relation to bond stripping?
What is the primary purpose of forward rate agreements (FRAs) based on the text?
What is the primary purpose of forward rate agreements (FRAs) based on the text?
How do forward interest rates help in the context of investments?
How do forward interest rates help in the context of investments?
What do spot interest rates represent in the context of bond investments?
What do spot interest rates represent in the context of bond investments?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What can lenders and borrowers trade with each other in derivative markets to do?
What can lenders and borrowers trade with each other in derivative markets to do?
What does a downward sloping Pales Diagram curve represent in terms of interest rates?
What does a downward sloping Pales Diagram curve represent in terms of interest rates?
What is the main implication of the Liquidity Premium Theory on longer-term bonds?
What is the main implication of the Liquidity Premium Theory on longer-term bonds?
How are forward rates expected to reflect the market's anticipated future spot rates according to the text?
How are forward rates expected to reflect the market's anticipated future spot rates according to the text?
Why are bank deposits not used to construct yield curves?
Why are bank deposits not used to construct yield curves?
What is the purpose of stripping bonds of their coupons in the boot strapping method?
What is the purpose of stripping bonds of their coupons in the boot strapping method?
Why are yields calculated on single payment instruments like BABs and NCDs for constructing yield curves?
Why are yields calculated on single payment instruments like BABs and NCDs for constructing yield curves?
What is the significance of using the boot strapping method in constructing yield curves?
What is the significance of using the boot strapping method in constructing yield curves?
In constructing yield curves, why are securities with little or no credit and liquidity risk preferred?
In constructing yield curves, why are securities with little or no credit and liquidity risk preferred?
What does a forward rate hedge against for a borrower?
What does a forward rate hedge against for a borrower?
In a forward rate agreement, if spot rates are lower than expected, who is compensated?
In a forward rate agreement, if spot rates are lower than expected, who is compensated?
What is the main drawback of using a forward rate for a lender?
What is the main drawback of using a forward rate for a lender?
How does the bootstrapping method impact the calculation of forward interest rates?
How does the bootstrapping method impact the calculation of forward interest rates?
What is the outcome of stripping coupon payments from bonds?
What is the outcome of stripping coupon payments from bonds?
What does a strip of FRAs hedge according to the text?
What does a strip of FRAs hedge according to the text?
What is the main advantage of using forward rate agreements (FRAs) based on the text?
What is the main advantage of using forward rate agreements (FRAs) based on the text?
In the FRA equation for cash settlement, what does $V_{ ext{market}}$ represent?
In the FRA equation for cash settlement, what does $V_{ ext{market}}$ represent?
Why is the bootstrapping method important for calculating forward interest rates?
Why is the bootstrapping method important for calculating forward interest rates?
What does a strip of bonds stripping entail according to the text?
What does a strip of bonds stripping entail according to the text?
What does an FRA contract aim to establish?
What does an FRA contract aim to establish?
How is the forward rate achieved in an FRA contract?
How is the forward rate achieved in an FRA contract?
What do both borrowers and lenders prefer to do instead of facing uncertainty with future spot rates?
What do both borrowers and lenders prefer to do instead of facing uncertainty with future spot rates?
In bond stripping, what happens when coupon payments are removed from the bonds?
In bond stripping, what happens when coupon payments are removed from the bonds?
What is the main purpose of using the bootstrapping method in calculating forward interest rates?
What is the main purpose of using the bootstrapping method in calculating forward interest rates?
What does an investor achieve by using forward rates in investments?
What does an investor achieve by using forward rates in investments?
Why are spot rates considered essential in the context of investments?
Why are spot rates considered essential in the context of investments?
What does stripping bonds involve according to the text?
What does stripping bonds involve according to the text?
What is a key benefit of using FRAs for investors and traders?
What is a key benefit of using FRAs for investors and traders?
What is the primary purpose of using the bootstrapping method in calculating forward interest rates?
What is the primary purpose of using the bootstrapping method in calculating forward interest rates?
What is the main purpose of stripping bonds?
What is the main purpose of stripping bonds?
What do forward rate agreements (FRAs) aim to establish?
What do forward rate agreements (FRAs) aim to establish?
What method is used to value individual bonds separately without the coupon payments in constructing yield curves?
What method is used to value individual bonds separately without the coupon payments in constructing yield curves?
What is the significance of spot interest rates in investments?
What is the significance of spot interest rates in investments?
What type of instruments are yields calculated on in constructing yield curves?
What type of instruments are yields calculated on in constructing yield curves?
What is the purpose of bonds stripping in the context of investments?
What is the purpose of bonds stripping in the context of investments?
What is the significance of using the boot strapping method in constructing yield curves?
What is the significance of using the boot strapping method in constructing yield curves?
What do forward rates help investors and traders hedge against?
What do forward rates help investors and traders hedge against?
What is stripped from bonds in the boot strapping method?
What is stripped from bonds in the boot strapping method?
What do spot interest rates represent in the context of bond investments?
What do spot interest rates represent in the context of bond investments?
How do forward interest rates help in the context of investments?
How do forward interest rates help in the context of investments?
In a forward rate agreement, what do FRAs hedge?
In a forward rate agreement, what do FRAs hedge?
What does bond stripping involve according to the text?
What does bond stripping involve according to the text?
What does a forward rate agreement involve?
What does a forward rate agreement involve?
What is the purpose of stripping bonds of their coupons in the bootstrapping method?
What is the purpose of stripping bonds of their coupons in the bootstrapping method?
How do forward interest rates help in the context of investments?
How do forward interest rates help in the context of investments?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What does an FRA contract aim to establish?
What does an FRA contract aim to establish?
What is the main difference between spot interest rates and forward interest rates?
What is the main difference between spot interest rates and forward interest rates?
What is the primary purpose of stripping bonds in the bootstrapping method?
What is the primary purpose of stripping bonds in the bootstrapping method?
How do forward rate agreements (FRAs) help investors and traders?
How do forward rate agreements (FRAs) help investors and traders?
What does a forward rate hedge against for a borrower?
What does a forward rate hedge against for a borrower?
What does the term structure of interest rates reflect?
What does the term structure of interest rates reflect?
What risk do floating rate borrowers face if future spot rates are higher than expected?
What risk do floating rate borrowers face if future spot rates are higher than expected?
Study Notes
The Term Structure of Interest Rates
- The term structure of interest rates refers to the set of interest rates for a class of assets (e.g., bonds, BABs, NCDs) for a range of terms.
- It represents the relationship between the interest rates of different financial instruments with different terms of time horizons.
- A yield curve is a graph of the term structure of interest rates at a particular point in time.
- Horizontal axis: time to maturity
- Vertical axis: YTM (Yield to Maturity) rates
- Each plot is for the next longer term security
- Yield curves are upward sloping, indicating that shorter-term interest rates are lower than longer-term interest rates, which reflects market expectations and economic growth.
- The level of long-term bond yields reflects inflation rate expectations, while the level of short-term rates reflects monetary policy.
The Liquidity Premium Theory
- The liquidity premium theory argues that yield curves include a price risk premium that is higher for long-term rates or may be expected to change.
- During the GFC, the credit risk premium that applies to banks increased, showing that the market imposes risk premiums that increase with term and influence yield curves.
- The theory states that investors are compensated for potential loss of liquidity from holding a long-term bond, resulting in higher rates to generate higher returns.
- The choice between investment strategies is biased by price risk.
Spot Interest Rates
- Spot interest rates are the current rate of interest for a range of terms.
- The term of the spot rate is given by the security's term to maturity.
- Spot rates can be referred to as orn (0 = starting date, n = ending date, e.g., 5 years).
Forward Interest Rates
- Forward interest rates commence at a future date and extend for a specific term.
- Forward interest rates are implicit in spot yields, but actual forwards are discovered in the futures market.
- Forward rates are used to determine the value of a forward rate agreement.
- Forward rates are important as they enable investors and traders to hedge against future interest rate risk.
Assessment of Yield Curve Theories
- In isolation, the liquidity premium theory does not explain non-normal yield curves.
- Variations in short-term rates are likely due to the market anticipating future changes in the cash rate, consistent with the unbiased expectations approach.
- Forward rates reflect the market's expected future spot rates, but these expectations may not always be correct.
Hedging Interest Rate Risk
- Risks for borrowers: chance of upside risk, where rates turn out lower than expected.
- Risks for lenders: chance of downside risk, where rates turn out higher than expected.
- Risk exposure of a company that plans to issue money market securities: risk of interest rates being higher than expected, causing proceeds to decrease.
Constructing Yield Curves
- Yield curves are constructed from the yields on traded securities (rather than bank deposits).
- The securities need to have little or no credit and liquidity risk.
- The yields need to be calculated on single payment instruments such as BABs and NCDs.
Normal Yield Curve
- Features: shorter interest rates are lower than longer-term ones.
- Slopes upward as shorter-term rates are lower than longer-term rates.
- In reality, yield curves are not perfectly formed and may be irregular, indicating something is happening in the economy that isn't normal.
Inverse Yield Curve
- Features: shorter interest rates are higher than longer-term ones.
- Associated with economic recession.
- Inverted yield curve implies investors expect economic growth to slow down.
Flat Yield Curve
- Features: generally similar rates regardless of security's term.
- Not a common occurrence, happens for a short amount of time during transitions from normal to inverse or inverse to normal.
- Happens when the economy is transitioning from recession to growth or from growth to recession.
Forward Rate Agreement (FRA)
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A contract with a bank that serves to establish a forward interest rate for a specified future date on a nominal principal for a set period.
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The FRA contract has no upfront cost and achieves the forward rate through the payment of a cash settlement.
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FRAs are common, well-established, and can be customized to meet specific needs of the parties involved.### Yield Curves
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A normal yield curve slopes upward as shorter-term interest rates are lower than longer-term rates
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Irregular shapes, such as inverse or flat yield curves, indicate unusual economic conditions
Constructing Yield Curves
- Yield curves are constructed from traded securities with little to no credit and liquidity risk
- Securities used include BABs and Treasury Bonds
- Yields are calculated from single payment instruments, such as BABs and NCDs
- Bonds are stripped of their coupons using a method called bootstrapping
Term Structure of Interest Rates
- The term structure of interest rates is a set of interest rates for a class of assets with different terms
- It shows the relationship between interest rates of different financial instruments with different time horizons
- A yield curve is a graph of the term structure of interest rates at a particular point in time
- The horizontal axis represents time to maturity, and the vertical axis represents yield to maturity (YTM) rates
Features of Yield Curves
- Upward sloping yield curves reflect market expectation of economic growth and inflation
- The level of long-term bond yields reflects inflation rate expectations
- The level of short-term rates reflects monetary policy
- Inverse yield curves indicate the expectation of spot rates being lower in future periods
- Flat yield curves indicate the expectation of interest rates remaining steady
Liquidity Premium Theory
- The theory argues that yield curves include a price risk premium that increases with term
- Investors are compensated for potential loss of liquidity that arises from holding long-term bonds
- The theory is only relevant for normal yield curves
- The implication is that the yield for longer-term securities will include a risk premium to compensate investors for price (i.e., liquidity) risk
Assessment of Yield Curve Theories
- In isolation, the liquidity premium theory does not explain non-normal yield curves
- Variations in short-term rates are most likely due to the market anticipating future changes in the cash rate
Hedging Interest Rate Risk
- Lenders and borrowers have opposite risk exposures and can trade with each other in derivative markets to hedge their exposures
- Borrowers face the risk of future spot rates being higher than expected, and can hedge using derivatives
- Companies that plan to issue money market securities face the risk of interest rates being higher than expected, which can decrease proceeds from the issue
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Description
Explore the liquidity premium theory, variations in short term rates, and hedging interest rate risk for lenders and borrowers. Understand how forward rates reflect market expectations of future spot rates and the risks involved in interest rate fluctuations.
