Reading 53: Term Structure and Volatility of Interest Rates- 2010, structure, interest, center, style

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Session 14: Fixed Income: Valuation Concepts
Reading 53: Term Structure and Volatility of Interest Rates

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

 

 

 

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) a coupon rate for the current period.

C) an interest rate for some future 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.

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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.

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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.

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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.

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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.

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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.

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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.

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A portfolio manager who believed in the liquidity premium theory would expect:

A) long-term securities to offer higher returns than short-term securities.

B) all of the choices are correct.

C) long-term rates to be higher than investors’ expectations of future rates, because of the liquidity premium.

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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, since they include a liquidity premium, are a biased estimate of the market’s expectation of future spot rates.

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If the liquidity preference hypothesis is true, what shape should the term structure curve have in a period where interest rates are expected to be constant?

A) Upward sweeping.

B) Downward sweeping.

C) Flat.

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The liquidity theory holds that investors demand a premium to compensate them for interest rate exposure and the premium increases with maturity. Add this premium to a flat curve and the result is an upward sloping yield curve.

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Which of the following is TRUE according to the pure expectations theory? Forward rates:

A) exclusively represent expected future spot rates.

B) are biased estimates of market expectations.

C) always overestimate future spot 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. Under the pure expectations theory, a yield curve that is upward (downward) sloping, means that short-term rates are expected to rise (fall). A flat yield curve implies that the market expects short-term rates to remain constant.