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Fabozzi:Investment Management
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Learning Objectives
• You will understand why the yield on a Treasury
security is the base interest rate.
• You will study the factors that affect the yield spread
between two bonds.
• You will be able to describe what a yield curve is.
• You will learn what a spot rate and a spot rate curve
mean.
• You will calculate the theoretical spot rates from the
Treasury yield curve.
Learning Objectives
• You will explore what the term structure of interest
rates is.
• You will study why the price of a Treasury bond should
be based on spot rates.
• You will learn what is meant by a forward rate and be
able to calculate a forward rate.
• You will explore how long-term rates are related to the
current short-term rate and short-term forward rates.
• You will understand the different theories about the
determinants of the shape of the term structure: pure
expectations theory, the liquidity theory, the preferred
habitat theory, and the market segmentation theory.
Introduction
Bond yields depend on a variety of factors, including
the type of issuer, the characteristics of the bond issue,
and the state of economy. In this chapter we look at the
following factors
Term to maturity
The longer the term to maturity, the greater the bond price volatility
Short-term bonds – maturity between 1 and 5 years
Intermediate-term bonds – maturity between 5 and 12 years
Long-term bonds – maturity > 12 years
94.47537 = 102.875
(1 + z3)3
That is, the annual rate for f on a bond equivalent basis = 5.75%
If the 6 month rate 6 months from now < 5.75%, then the investor
should go with alternative one since the total value will be higher.
It is important to understand that expectations of future rates are
built into the rates offered on investments with different maturities.
Forward rate – future interest rate calculated from spot rates or the
yield curve
Relationship between six-month
forward rates and spot rates
Given a t-period spot rate, the current spot rate and six
month forward rates (ft), the formula for the relationship is