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What is meant by term structure of interest rates?
It is the relationship between the interest rate on a security and its time to maturity or observed market yields for interest bearing investments of various maturities. The relationships between interest rates or bond yields and different terms or maturities.
What is a yield curve?
Graphical representation of the term structure of interest rates. Plot of YTM as a function of time to maturity. Graphically shoes the relationship between yield on a bond and the time to maturity on the bond.
Why do we typically use US treasury securities to construct a yield curve?
Because they are free of default risk. It is intended for pure time value of money comparison of rates.
What various shapes may a yield curve have?
There are flat yield curve, risking yield curve, inverted, and hump shaped.
Which shapes are considered "normal" and "inverted?"
Rising yield curve is considered to be normal and inverted is opposite.
What are the two theories that may explain the term structure of interest rates?
Expectation hypothesis and Liquidity preference hypothesis.
current sport rates reflect expected future sport rates; forward rates reflect markets unbiased expectation of the future short rates. Or A common version of this hypothesis states that the forward rate equals the market consensus expectation of the future short rate and liquidity premium is zero.
Observation that, all else being equal, people prefer to hold on to cash and that they will demand a premium for investing in non-liquid assets such as bonds, stocks, etc. If they are investing longer, you need to give me more cash.
Flat yield curve
shoer and long-term rates are equal, implies that expectation of steady rates.
Rising yield curve
Long-term rates higher than short-term rates; implies expectation of higher future short rates
Long-term lower; expected fall in rates
Expect rates to go up and down, risk and fall
What is a spot interest rate?
The rate that prevails today for a time period corresponding to the zero's maturity. Or observed yield for various maturities today. The interest rate or exchange rate on a contract on the current market.
What is a forward rate?
Future interest rate inferred from current sport rates. Rates are based on sport rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time. A projection of future interest rates calculated from either sport rates or yield curve.
What is a short rate?
Current interest rate for certain period of time period. Interest rate for that interval available at different points in time.
How are forward rates and future spot rates related under the expectations theory?
According to expectations theory, forward rate reflect expected future progress. Because forward rates are mathematical reality that we extract. Because the liquidity premium is zero, the forward rate is equal to the market's expectation of the future short rate.
How are forward rates and future spot rates related under the liquidity preference theory?
It specifies that the liquidity premium is positive so that the forward rate is greater than the market's expectation. (expected future spot rate and risk premium)
What is the risk difference between holding short-term securities and planning to roll over and holding long term securities and planning to sell prior to maturity?
Investor with long-term investment horizon face risk of Rn > Fn, falling future prices. Investors with shorter
Which type of investor dominates the market under the liquidity preference theory?
Investors with short-term investment horizon dominate it
What is the risk premium under the liquidity preference theory and how is it related to forward rates and expected future short rates?
People are expecting a payoff because they cant have liquidity
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