Mechanic

Which of the following most accurately explains the "break-even-rate" interpretation of forward rates? The forward rate is the rate that will make an investor indifferent between investing:

A) investing at the spot or forward interest rate.

B) for the full investment horizon, or for part of it, and then rolling over the proceeds for the balance of the investment horizon at the forward rate.

C) now or at a forward time.

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The pure expectations theory can be explained using a “break-even rate” line of reasoning. The break even rate is the forward rate that leaves investors indifferent between investing for the full term of their investment horizon or investing in part of the horizon and rolling the investment over at the “break-even” forward rate for the remainder of the term.

Mechanic

The liquidity theory of the term structure of interest rates is a variation of the pure expectations theory that explains why:

A) duration is an imprecise measure.

B) the yield curve usually slopes downward.

C) the yield curve usually slopes upward.

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The pure expectations hypothesis says that the shape of the yield curve only reflects expectations of future short-term rates. Yet, the yield curve generally slopes upward. The liquidity theory says that the yield curve incorporates expectations of short-term rates; however, the tendency for the yield curve to slope upward reflects the demand for a higher return to compensate investors for the extra interest rate risk associated with bonds with longer maturities.

Mechanic

Which theory explains the shape of the yield curve by considering the relative demands for various maturities?

A) The liquidity premium theory.

B) The segmentation theory.

C) The pure expectations theory.

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The market segmentation theory contends that lenders and borrowers have preferred maturity ranges, and that supply and demand forces in each maturity range determines yields. This theory relies on the idea that some investors have restrictions (either legal or practical) on their preferred maturity structure and that they are unwilling or unable to move out of their preferred ranges.

Mechanic

Assuming the pure expectations theory is correct, an upward sloping yield curve implies:

A) longer-term bonds are riskier than short-term bonds.

B) interest rates are expected to increase in the future.

C) interest rates are expected to decline in the future.

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The yield curve slopes upward because short-term rates are lower than long-term rates. Since market rates are determined by supply and demand, it follows that investors (demand side) expect rates to be higher in the future than in the near-term.

Mechanic

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

A) expected future spot rates.

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

C) equal to futures rates.

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The pure expectations theory, also referred to as the unbiased expectations theory, purports that forward rates are solely a function of expected future spot rates. This implies that long-term interest rates represent the geometric mean of future expected short-term rates, nothing more.

Mechanic

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

A) equal to futures rates.

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

C) expected future spot rates.

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The liquidity theory of the term structure proposes that forward rates reflect investors’ expectations of future rates plus a liquidity premium to compensate them for exposure to interest rate risk, and this liquidity premium is positively related to maturity. The implication of the liquidity theory is that forward rates are a biased estimate of the market’s expectation of future rates, since they include a liquidity premium.

Mechanic

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.

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The pure expectations theory can be explained using a “locked-in-rate” line of reasoning, whereby forward rates are interpreted as the rate that can be “locked in” for some future period.

Mechanic

There has been an increasing trend to measuring corporate credit spreads relative to which of the following security classes?

A) Mortgage-backed securities.

B) Swaps.

C) Treasury securities.

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Due to the size and extensive use of the swap market there has been a shift from corporate credit spreads based on Treasuries to credit spreads linked to swaps.

Mechanic

Compared to a yield curve based on government bonds, swap rate curves are:

A) more comparable across countries and have a greater number of yields at various maturities.

B) less comparable across countries and have a greater number of yields at various maturities.

C) more comparable across countries and have a smaller number of yields at various maturities.

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Swap rate curves are typically determined by dollar denominated borrowing based on LIBOR. These rates are determined by market participants and are not regulated by governments. Swap rate curves are not affected by technical market factors that affect the yields on government bonds. Swap rate curves are also not subject to sovereign credit risk (potential government default on debt) that is unique to government debt in each country. Thus swap rate curves are more comparable across countries because they reflect similar levels of credit risk. There is also a wider variety of maturities available for swap rate curves, relative to a yield curve based on US Treasury securities, which has only four on-the-run maturities of two years or more. Swap rate curves typically have 11 quotes for maturities between 2 and 30 years.

Mechanic

Which of the following is NOT a reason why market participants prefer the swap rate curve over a government bond yield curve? The swap market:

A) reflects sovereign credit risk.

B) it is not affected by technical factors.

C) is free of government regulation.

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Swap rate curves are typically determined by dollar denominated borrowing based on LIBOR. These rates are determined by market participants and are not regulated by governments. Swap rate curves are not affected by technical market factors that affect the yields on government bonds. The swap rate curve is also not subject to sovereign credit risk (potential government default on debt) that is unique to each country.