Presentation_3-2_mar - The term structure of interest rates Econ 230 Financial Markets and Institutions Prof Cahill Fall 2009 The yield curve Plot

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The term structure of interest rates Econ 230 Financial Markets and Institutions Prof. Cahill Fall 2009
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The yield curve Plot of the yield to maturity of bonds with different terms to maturity Standard: use U.S. Treasury bonds Elsewhere: swap rate yield curve/LIBOR curve Use securities with no default risk, high liquidity Spreads represent maturity premium only Ideally use zero coupon bonds
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Swap rate yield curve Generic (“vanilla” or “bullet”) interest rate swap 1 party pays a variable rate (usually tied to LIBOR) Counterparty pays a fixed rate, the “swap rate” Should be the avg. exp. variable rate over lifetime of swap Different swap rates for different contract lengths Not default or liquidity risk free, but close Used as standard in most of rest of the world
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Shapes of the yield curve Normal Flat Inverted i Term to maturity i Term to maturity i Term to maturity
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How to calculate with coupon bonds? Bootstrapping method z t is the rate on a zero coupon bond with maturity t e.g. 2 year bond w/ annual CF : CF 1 , CF 2 , M Text does 6-month coupon payments You observe 1 year zero coupon rate from market ( z 1 ) P = CF 1 / (1+ z 1 ) + ( CF 2 + M )/ (1+ z 2 ) 2 Use known P , CF , M and z 1 from market Solve for z 2 , the 2-year spot rate Repeat for every maturity Yield curve uses these zero-coupon equivalent spot rates
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How to calculate with coupon bonds? Bootstrapping method example CF = 50, M = 1,000, z 1 =3%, i 2 = 6%, n = 2 P = 981.67 = 50/1.06 + 1050/1.06 2 P = CF 1 / (1+ z 1 ) + ( CF 2 + M )/ (1+ z 2 ) 2 981.67 = 50/(1.03) + 1050/ (1+ z 2 ) 2 (1+ z 2 ) 2 = 1050/933.12 = 1.125 (1+ z 2 ) =1.061 z 2 = 6.1%
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This note was uploaded on 02/19/2010 for the course ECON 1313212 taught by Professor John during the Spring '09 term at The School of the Art Institute of Chicago.

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Presentation_3-2_mar - The term structure of interest rates Econ 230 Financial Markets and Institutions Prof Cahill Fall 2009 The yield curve Plot

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