Yield Curve and Interest Rates Theory

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Questions and Answers

What does the expectations theory suggest about the shape of the yield curve?

It implies that the two-year interest rate equals two successive one-year rates. (correct)

It suggests that longer-term rates predict future short-term rates.

It reflects investor preferences for short-term over long-term investments.

It indicates volatility in interest rate movements.

Given a current one-year bond rate of 4%, what must the second year's one-year bond return be to match the return of a two-year bond at 5%?

8.25%

6.25% (correct)

7.25%

7.00%

If an investor buys a six-month bond and plans to reinvest, how many times will they need to reinvest over two years?

Four times (correct)

Three times

Two times

Five times

How is the one-year rate related to the rates of two consecutive six-month bonds according to the expectations theory?

The one-year rate is an average of the two consecutive six-month rates. Signup and view all the answers

What is the calculated return on investment for a two-year bond with a rate of 5% at maturity?

10.25% Signup and view all the answers

Which choice allows an investor to maintain equal attractiveness in the fixed-income market?

Purchasing either a two-year bond or a combination of shorter bonds. Signup and view all the answers

What is the total minimum account balance required if a client wishes to sell short 100 shares of FED Company Ltd. at $5.00?

$750.00 Signup and view all the answers

If FED's share price decreases to $4.00, what is the new minimum margin required?

$100.00 Signup and view all the answers

What is the excess margin after the client has sold short at $5.00 and the share price drops to $4.00?

$150.00 Signup and view all the answers

What will happen if the price of FED shares rises after a drop to $4.00?

The client will receive a margin call. Signup and view all the answers

When the share price of FED decreases to $1.60, how is the required account balance governed?

It is governed by the new lower price, leading to a new calculation. Signup and view all the answers

Which component is NOT included in the calculation of the minimum account balance required?

Commissions for the trade Signup and view all the answers

What is the percentage margin required for the short sale of FED shares?

50% Signup and view all the answers

After selling short 100 shares of FED at $5.00, how much margin must the client deposit?

$250.00 Signup and view all the answers

What is the primary characteristic of a day order?

It is only valid until the close of business on the same day it is placed. Signup and view all the answers

What differentiates a good til date (GTD) order from a good til cancelled (GTC) order?

A GTD order expires on a specific date set by the investor. Signup and view all the answers

How does an on-stop sell order function?

It is triggered when the stock price drops below a specified level. Signup and view all the answers

What must occur for an on-stop sell order to become active on the Toronto Stock Exchange?

It must have a limit price attached upon entry. Signup and view all the answers

What is the maximum duration for a good til cancelled (GTC) order?

90 calendar days from entry unless cancelled earlier. Signup and view all the answers

In what scenario is an on-stop sell order particularly useful?

When minimizing potential losses from a stock price decline. Signup and view all the answers

What is the minimum account balance required based on the market value before the price change?

$900.00 Signup and view all the answers

What is the margin deficiency that triggers a margin call when the price rises to $6.00?

$150.00 Signup and view all the answers

When FED’s share price is at $6.00, how much margin is required in total?

$400.00 Signup and view all the answers

How are profits or losses on short sales calculated?

In the same way as on a long transaction. Signup and view all the answers

Which of the following best describes the impact of a price increase to $6.00 on the margin balance?

An increase in the margin requirement results in a deficiency. Signup and view all the answers

What percentage of the market value is used to determine the minimum account balance required before a potential margin call?

150% Signup and view all the answers

How much is the initial amount deposited in the margin account?

$250.00 Signup and view all the answers

In what scenario is no additional margin required despite the share trading conditions?

When the required balance is less than the short sale proceeds. Signup and view all the answers

What was the total proceeds from the initial short sale at $5.00 per share for 100 shares?

$500.00 Signup and view all the answers

What factor triggers a margin call in this scenario?

An increase in the share price beyond a certain threshold. Signup and view all the answers

Study Notes

Yield Curve and Investor Expectations

The yield curve reflects investor expectations regarding future interest rates.
Efficiency in the market leads to equal attractiveness among different investment strategies (e.g., two-year bond vs. rolling one-year bonds).
The two-year interest rate equals two consecutive one-year rates, while the one-year rate is the average of two consecutive six-month rates.

Investment Example

A two-year bond offers a current rate of 5%, yielding a total return of 10.25% at maturity (calculated as 1.05 × 1.05).
To match the return of a two-year bond, the average return of two successive one-year bonds must align with the two-year rate.

Margin Requirements in Short Selling

Short-selling involves selling borrowed shares to benefit from anticipated price declines.
Minimum account balance required for short selling includes proceeds from the sale plus a margin (50% of the market value).
If a share price drops, the client may enjoy excess margin, which can be used for further investments.

Short Sale Scenarios

Scenario 1: If the share price drops to $4, the margin requirement lessens. The client has excess margin that can be utilized.
Scenario 2: If shares fall to $1.60, no additional margin is needed due to a lower minimum balance requirement.
Scenario 3: If shares rise to $6, a margin call is issued as a deficiency arises (margin required exceeds deposited amount).

Profit and Loss on Short Sales

Profit or loss calculations on short sales mirror those of long transactions.
Orders are classified as day orders unless specified otherwise (e.g., good til date or good til cancelled).

Order Types

Day Orders expire at the end of the trading day if not executed.
Good Til Date (GTD) orders remain valid until a specified date is reached.
Good Til Canceled (GTC) orders last 90 days unless canceled earlier.

On-Stop Sell Orders

An on-stop sell order is aimed at limiting losses; it triggers a sell when the stock price falls to a predetermined level.
All on-stop sell orders on exchanges must have a limit price attached.

Real Rate of Return

The real rate of return comprises the nominal rate adjusted for inflation.
Determined by the balance of funds supplied by investors and demand for loans from businesses.
The nominal rate = Real Rate + Inflation Rate.

Factors Affecting the Real Rate of Return

The real interest rate fluctuates with the business cycle, generally decreasing during recessions and increasing with economic expansion.
Inflation rate changes can impact forecasts for the real rate; unexpected inflation diminishes the real rate of return for lenders.

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Description

This quiz explores the expectations theory of the yield curve and its implications for investor decisions in the fixed-income market. It discusses the options available to investors based on their investment timeline and how these choices reflect future interest rate expectations.