LOS e: Illustrate the various theories of the term structure of interest rates (i.e., pure expectations, liquidity, and preferred habitat) and the implications of each theory for the shape of the yield curve.

Q1. Which of the following most accurately explains the "locked-in-rate" interpretation of forward rates? The forward rate allows an investor to lock in:

A)   a coupon rate for some future period.

B)   an interest rate for some future period.

C)   a coupon rate for the current period.

Q2. According to the liquidity theory, how are forward rates interpreted? Forward rates are:

A)   equal to futures rates.

B)   expected future spot rates.

C)   expected future spot rate plus a rate exposure premium.

Q3. James Wallace, CFA, is a fixed income fund manager at a large investment firm. Each year, the firm recruits a group of new college graduates in the spring to enter in the firm’s management training program. The program is a rigorous six-month course that exposes every candidate to each of the different departments within the firm. After successfully completing the six-month training period, candidates then receive offers for employment in one of the departments within the investment firm. Recently, Wallace was selected by his boss to teach the fixed income portion of the firm's training program. He will be able to hold several two-hour sessions with the new hires over a two-week time period, during which he is expected to instruct the trainee’s on all aspects of fixed income analysis. These sessions serve as preparation for the trainees to be able to complete a month long rotation on the fixed income trading desk. 

His first few sessions will cover the core concepts of fixed income investing. Wallace believes that in order to fully grasp the more complicated concepts of fixed income analysis, the new hires must first begin by having a complete knowledge of the term structure and the volatility of interest rates. The new hires each have different educational backgrounds and varying amounts of work experience, so Wallace decides to begin with the most very basic concepts. He wants to start by teaching the various theories of the term structure of interest rates, and the implications of each theory for the shape of the Treasure yield curve. To evaluate the trainees' understanding of the subjects at hand, he creates a series of questions.

The following interest rate scenario is used to derive examples on the different theories used to explain the shape of the term structure and for all computational problems in Wallace's lectures.

James uses a rounded day count of 0.5 years for each semi-annual period.

Following Wallace's first lecture he asks the trainees which of the following explains an upward sloping yield curve according to the (unbiased) pure expectations theory of the term structure of interest rates?

A)   The market expects short-term rates to rise through the relevant future.

B)   There is greater demand for short-term securities than for long-term securities.

C)   There is a risk premium associated with more distant maturities.

Q4. Wallace now poses a similar question regarding the liquidity preference theory. Which of the following could explain an upward sloping yield curve according to the liquidity preference theory of the term structure of interest rates?

A)   There is greater demand for short-term securities than for long-term securities.

B)   There is a risk premium associated with more distant maturities.

C)   The market expects short-term rates to rise through the relevant future.

Q5. Wallace explains to the class that the swap fixed rate is one where the values of the floating-rate and the fixed-rate are the same at the inception of the swap. Using the information in Table 1, he asks the class to compute the swap fixed rate for a one-year plain vanilla interest rate swap with semiannual payments. Which of the following is the closest to the correct answer?

A)   3.43%.

B)   5.18%.

C)   2.56%.

Q6. Wallace finally asks the class about the market segmentation theory of the term structure of interest rates. Specifically, Wallace asks which of the following could explain an upward sloping yield curve according to the market segmentation theory?

A)   There is greater demand for short-term securities than for long-term securities.

B)   There is greater demand for long-term securities than for short-term securities.

C)   There is a risk premium associated with more distant maturities.

Q7. Wallace presents the relationships between spot and forward rates according to the pure expectations theory. Which of the following is closest to the one-year implied forward rate one year from now?

A)   6.58%.

B)   6.25%.

C)   5.75%.

Q8. Wallace completes his first lecture by tying the relationship between Treasury prices and the shape of the term structure. He is particularly interested in the implications of a steepening yield curve. Which of the following is most accurate for a steepening yield curve?

A)   The price of short-term Treasury securities increases relative to the price of long-term Treasury securities.

B)   The price of long-term Treasury securities increases relative to the price of short-term Treasury securities.

C)   The price of short-term Treasury securities increases.

Q9. According to the pure expectations theory, how are forward rates interpreted? Forward rates are:

A)   expected future spot rates if the risk premium is equal to zero.

B)   equal to futures rates.

C)   expected future spot rates.

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