Term structure of interest rate and managing bond portfolio

Question 1

Explain the difference between the spot rate, the forward rate and the short rate. Does an
upward sloping yield curve necessarily imply an increasing expectation of future short rates?

Answer 1

• Spot rate and forward rate: known today as they can be observed/calculated from the
  yield curve.
• Short rate: future interest rate that is unknown now and can only be predicted.
• Upward sloping yield curve does not necessarily imply an increasing expectation of
  future short rates.
  o Upward sloping yield curve implies increasing forward rates over time.
  o Under the expectation hypothesis when all investors are risk-neutral, forward
  rates are identical to expected future short rates.
  o In view of the liquidity preference theory, short-term investors require positive
  liquidity premium, which can generate increasing forward rates even when the
  future short rates are constant or decreasing.

Question 2

Explain the concept of immunization and why it can be used to neutralized interest rate risk of
a bond portfolio. What are the potential problems of this strategy?

Answer 2

Immunization is a strategy to mitigate the interest rate risk of a bond portfolio by
matching the duration of the portfolio to the target investment horizon.
* An immunized portfolio has zero interest rate risk because the price risk and the
reinvestment risk perfectly offset each other.