Exam 7: The Term Structure and Interest Rate Dynamics

If a bond trader believes that current forward rates overstate future spot rates, how might he or she profit from that conclusion?

The following information relates to Questions 49-57liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds issued in Countries A, b, and -based on Exhibit 1 and assuming Tyo's market views on yield curve changes are realized, the forward curve of which country will lie below its spot curve?

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged. ExHIbIT 1 Government Spot Rates and Swap Spreads Maturity (years) 1 2 3 4 Government spot rate 2.25\% 2.70\% 3.30\% 4.05\% Swap spread 0.25\% 0.30\% 0.45\% 0.70\% Smith decides to examine the following three investment options for Mathews: Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments. Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields. Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps. When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past. -In presenting Investment 1, using Shire Gate Advisers' interest rate outlook, Smith could show that riding the yield curve provides a total return that is most likely:

describe the relationship between forward rates and spot rates if the yield curve is flat.

describe how the Z-spread can be used to price a bond.

The following information relates to Questions 30-36 Jane nguyen is a senior bond trader and Christine Alexander is a junior bond trader for an investment bank. nguyen is responsible for her own trading activities and also for providing assignments to Alexander that will develop her skills and create profitable trade ideas. Exhibit 1 presents the current par and spot rates. EXHIBIT 1 Current Par and Spot Rates Maturity Par Rate Spot Rate One year 2.50\% 2.50\% Two years 2.99\% 3.00\% (continued) (Continued) Maturity Par Rate Spot Rate Three years 3.48\% 3.50\% Four years 3.95\% 4.00\% Five years 4.37\% Note: Par and spot rates are based on nnual-coupon sovereign bonds. nguyen gives Alexander two assignments that involve researching various questions: Assignment 1: What is the yield to maturity of the option-free, default risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1. EXHIBIT 2 Selected Data for \ 1,000 Par Bond Bond Name Maturity (T) Coupon Bond Z Three years 6.00\% Note: Terms are today for a T-year loan. Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is bond Z fairly valued, undervalued, or overvalued? After completing her assignments, Alexander asks about nguyen's current trading activ- ities. nguyen states that she has a two-year investment horizon and will purchase bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows nguyen's yield curve assumptions implied by the spot rates. -For Assignment 1, the yield to maturity for bond Z is closest to the:

Madison's views on the term structure of interest rates are most consistent with the:

Compare the segmented market and the preferred habitat term structure theories.

laura Mathews recently hired Robert Smith, an investment adviser at Shire Gate Advisers, to assist her in investing. Mathews states that her investment time horizon is short, approximately two years or less. Smith gathers information on spot rates for on-the-run annual-coupon gov-ernment securities and swap spreads, as presented in Exhibit 1. Shire Gate Advisers recently published a report for its clients stating its belief that, based on the weakness in the financial markets, interest rates will remain stable, the yield curve will not change its level or shape for the next two years, and swap spreads will also remain unchanged. ExHIbIT 1 Government Spot Rates and Swap Spreads Maturity (years) 1 2 3 4 Government spot rate 2.25\% 2.70\% 3.30\% 4.05\% Swap spread 0.25\% 0.30\% 0.45\% 0.70\% Smith decides to examine the following three investment options for Mathews: Investment 1: Buy a government security that would have an annualized return that is nearly risk free. Smith is considering two possible implementations: a two-year investment or a combination of two one-year investments. Investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields. Investment 3: Buy a lower-quality, two-year corporate bond with a coupon rate of $4.15 \%$ and a Z-spread of 65 bps. When Smith meets with Mathews to present these choices, Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be used as a good indicator of the risk and liquidity of money market securities during the recent past. -The bond in Investment 3 is most likely trading at a price of:

The following information relates to Questions 16-29 -The rate for a one-year loan beginning in one year is closest to:

The following information relates to Questions 49-57liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds issued in Countries A, b, and -based on Exhibit 1 and Tyo's expectations for the yield curves, Tyo most likely perceives the bonds of which country to be fairly valued?

The following information relates to Questions 16-29 -Which term structure model can be calibrated to closely fit an observed yield curve?

If one-period forward rates are decreasing with maturity, the yield curve is most likely:

The following information relates to Questions 16-29 -The forward rate for a one-year loan beginning in two years is closest to:

The following information relates to Questions 49-57liz Tyo is a fund manager for an actively managed global fixed-income fund that buys bonds issued in Countries A, b, and -based on Exhibit 1 and Tyo's expectations, which country's term structure is currently best for traders seeking to ride the yield curve?

The following information relates to Questions 16-29 -Given the yield curve for uS Treasury zero-coupon bonds, which spread is most helpful pricing a corporate bond? The: