Lecture 7: Interest Rates Flashcards
How are FIs different from other Non-financial firms in respect to interest rate sensitivity?
FIs are different from other Non-financial firms because both
sides of a FI’s balance sheet are sensitive to movements in interest rates.
• Value of longer dated investment instruments => more sensitive to i-rate movements than ST maturity investments
• i-rate changes lead to changes in value of both assets & liabilities => value of FIs.
What is the term structure of interest rates?
Term structure of interest rates = the relationship between interest rates and the term to maturity.
How is this structure geometrically plotted?
as yield curve
What is a yield curve?
Yield Curves= a graph plot of interest rates or yields against the maturity of the instrument.
Why the relationship between yield and maturity is not always the same?
The relationship changes as interest rates change
What are we able to predict from the yield curve?
forward rate
Forward rate serves as benchmark rate for what?
identifying incorrectly priced fixed income securities and for setting the interest sensitivity of a bank’s balance sheet.
How is the forward rate is calculated?
from the current term structure of interest rates:
1+Yn)^n = (1+Y)^n-1 x (1+Fn
Theories of Term Structure of Interest Rates
- Pure (or unbiased) expectations theory
2. Liquidity/ Risk Premium Theory
Definition of a standard bond:
A financial claim by which the issuer, or the borrower is committed to paying back to the bondholder, or the lender,
the cash amount borrowed, called principal, plus periodic
interests, called coupon, calculated on this amount during a given period of time.
There are 3 measurements of interest rate sensitivity
- Duration
- Gap Analysis
- Sensitivity Analysis
Duration is:- (2 things)
- A measure for judging sensitivity of an asset’s price to changes in the overall level of interest rates
- Defined as the weighted average time to receipt of a security’s cash flows, where the weights are the present value of the cash flow at each time relative to total present value.
Useful way of thinking about duration is that it
measures:
measures the average time to receipt of the bond’s cash flows
Duration weighs the cash flows according to:
their payment schedule giving a weighted average time for cash receipts – the closer that figure is to the maturity of the asset, the more sensitive it is to interest rate changes
Duration – Zero coupon Vs Coupon Bonds; What bond which will be affected the most by change in IR?
The bond which will be affected the most is a zero coupon bond – a bond that has only a single payment at maturity.
