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Session 15: Fixed Income: Basic Concepts

LOS d: Define a spot rate.

The Treasury spot rate yield curve is closest to which of the following curves?

 A) Par bond yield curve.
 B) Zero-coupon bond yield curve.
 C) Forward yield curve rate.

The spot rate yield curve shows the appropriate rates for discounting single cash flows occuring at different times in the future. Conceptually, these rates are equivalent to yields on zero-coupon bonds. The par bond yield curve shows the YTMs on coupon bonds by maturity. Forward rates are expected future short-term rates.

James McDonald and Veasna Lu were discussing different ways of valuing a Treasury security. During their discussion Lu made the following statements:

Statement 1: It is inappropriate to discount the cash flows of a Treasury security by a single discount rate because that is implicitly assuming that the yield curve is flat. Therefore, each individual cash flow should be discounted by its corresponding spot rate.

Statement 2: The spot rates used for different time periods that produce a value equal to the market price of a Treasury bond are called forward rates or future expected spot rates.

With regard to the statements made by Lu:

 A) both are correct.
 B) both are incorrect.
 C) only one is correct.

Statement 2 is incorrect because the spot rates used for different time periods that produce a value equal to the market price of a Treasury bond are called arbitrage-free Treasury spot rates. Statement 1 is correct.

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