Exam 11: The Term Structure of Interest Rates

There is a drawback to the pure expectations theory in that it does not consider the risks associated with investing in bonds. Nonetheless, there is risk in holding a long-term bond for one period, and that risk increases with the bond's maturity because maturity and price volatility are directly related. Given this uncertainty, and the reasonable consideration that investors typically do not like uncertainty, some economists and financial analysts have suggested a different theory. What is this theory and explain its relevance including its suggestions about implicit forward rates and yield curve.

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(Essay)

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Question 1

Correct Answer:

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The theory is the liquidity theory (often called the liquidity theory of the term structure) and its states that investors will hold longer-term maturities if they are offered a long-term rate higher than the average of expected future rates by a risk premium that is positively related to the term to maturity. Put differently, the forward rates should reflect both interest rate expectations and a "liquidity" premium (really a risk premium), and the premium should be higher for longer maturities. The liquidity theory suggests that the implicit forward rates will not be an unbiased estimate of the market's expectations of future interest rates because they embody a liquidity premium. Thus, an upward-sloping yield curve may reflect expectations that future interest rates either (1) will rise, or (2) will be flat or even fall, but with a liquidity premium increasing fast enough with maturity so as to produce an upward-sloping yield curve.

If the implied forward rates are realized, an investor that buys a six-month Treasury bill (and reinvests the proceeds every six months for five years) will produce the same number of dollars as an investment in a zero-coupon Treasury security at the five-year spot rate.

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(True/False)

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Question 2

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Ilmanen investigated the effect of the behavior of ________ using historical average returns on U.S. Treasury securities.

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(Multiple Choice)

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Question 3

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Studies have demonstrated that forward rates do a good job in predicting future interest rates.

(True/False)

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Question 4

What is the forward rate (f) for if the six-month spot rate is 5% and the one-year spot rate is 9%?

(Multiple Choice)

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Question 5

Which of the below statements is FALSE?

(Multiple Choice)

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Question 6

What is the forward rate (f) for a six-month security if z₁ is 2.00% and z₂ is 3.50%?

(Multiple Choice)

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Question 7

Which of the below statements is TRUE?

(Multiple Choice)

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Question 8

Consider the following two investment alternatives for an investor who has a one-year investment horizon. For Alternative 1, the investor buys a one-year instrument. For alternative 2, the investor buys a six-month instrument and when it matures in six months the investor buys another six-month instrument. Which of the below statements is FALSE?

(Multiple Choice)

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Question 9

Convexity biases are the expected return differentials across Treasury securities of different maturities.

(True/False)

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Question 10

Name and comment on two of the three main influences on the shape of the Treasury yield curve as suggested by empirical research.

(Essay)

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Question 11

A Treasury bill is a zero-coupon instrument. Therefore, its annualized yield is equal to the spot rate. Similarly, for the one-year Treasury, its cited yield is the one-year spot rate. Given these two spot rates, we can compute the spot rate for ________.

(Multiple Choice)

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Question 12

The empirical evidence suggests that at the front end of the yield curve (i.e., up to a duration of 3), bond risk premiums increase steeply with duration.

(True/False)

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Question 13

Which of the below equations give the forward rate (f) for a six-month security if z₁ is the six-month spot rate and z₂ is the one-year spot rate?

(Multiple Choice)

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Question 14

The concept of ________ suggests that when interest rates change by a large number of basis points, a Treasury security's price change will not be the same for an increase and decrease in interest rates.

(Multiple Choice)

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Question 15

There are risks that cause uncertainty about the return over some investment horizon. Which of the below is ONE of these risks?

(Multiple Choice)

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Question 16

By convention, when the maturity spread for a Treasury security is more than 100 basis points, the yield curve is said to be a steep yield curve.

(True/False)

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Question 17

Suppose that the six-month spot rate is 4.00% and one-year spot rate is 8.10%. Additionally, suppose that you can look into a crystal ball and know for sure that six months from now that the six-month rate will be 3.60%. Finally, suppose that there is an investor who expects that six months from now, the six month rate will be 4.10%. That is, the investor expects that the six-month rate will be higher than its current level of 4.00%. How would you advise an investor who wants to buy a six-month instrument and when it matures in six months buy another six-month instrument?

(Multiple Choice)

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Question 18

Ilmanen argues that the ________ is the least well known of the three main influences.

(Multiple Choice)

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Question 19

For the liquidity theory, the shape of the yield curve is determined by supply of and demand for securities within each maturity sector.

(True/False)

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Question 20

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Exam 11: The Term Structure of Interest Rates

If the implied forward rates are realized, an investor that buys a six-month Treasury bill (and reinvests the proceeds every six months for five years) will produce the same number of dollars as an investment in a zero-coupon Treasury security at the five-year spot rate.

Ilmanen investigated the effect of the behavior of ________ using historical average returns on U.S. Treasury securities.

Studies have demonstrated that forward rates do a good job in predicting future interest rates.

What is the forward rate (f) for if the six-month spot rate is 5% and the one-year spot rate is 9%?

Which of the below statements is FALSE?

What is the forward rate (f) for a six-month security if z₁ is 2.00% and z₂ is 3.50%?

Which of the below statements is TRUE?

Convexity biases are the expected return differentials across Treasury securities of different maturities.

Name and comment on two of the three main influences on the shape of the Treasury yield curve as suggested by empirical research.

A Treasury bill is a zero-coupon instrument. Therefore, its annualized yield is equal to the spot rate. Similarly, for the one-year Treasury, its cited yield is the one-year spot rate. Given these two spot rates, we can compute the spot rate for ________.

The empirical evidence suggests that at the front end of the yield curve (i.e., up to a duration of 3), bond risk premiums increase steeply with duration.

Which of the below equations give the forward rate (f) for a six-month security if z₁ is the six-month spot rate and z₂ is the one-year spot rate?

The concept of ________ suggests that when interest rates change by a large number of basis points, a Treasury security's price change will not be the same for an increase and decrease in interest rates.

There are risks that cause uncertainty about the return over some investment horizon. Which of the below is ONE of these risks?

By convention, when the maturity spread for a Treasury security is more than 100 basis points, the yield curve is said to be a steep yield curve.

Ilmanen argues that the ________ is the least well known of the three main influences.

For the liquidity theory, the shape of the yield curve is determined by supply of and demand for securities within each maturity sector.

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