03rec7

03rec7 - 15.407 Recitation November 5, 2003 MIT Sloan...

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Unformatted text preview: 15.407 Recitation November 5, 2003 MIT Sloan School of Management Interest rates and risks: Things to cover today: 1. Theory of interest rates 2. Risk and its measurements Characteristics of interest rates: (Nominal) positive Upward sloping in general Low volatility Mean Reverting Big market, can be very risky leverage is high! Three factors explain almost all of variations in interest rates: level, slope and curvature. So, how can we model interest rates? Models of interest rates: Endowment model Expectation/Liquidity Hypothesis Models of the term structure Model of endowment This is the usual utility maximization problem: Max U(c) given endowment. See class note for an example. You can build in more assumptions about the model. However, these models do a very poor job explaining interest rates. Expectation hypothesis: f t,k = E [ r t,k ]. t denotes the starting date of the rate and k denotes the duration of the in- terest rate. i.e. f 1 , 1 is the one year forward of the one year interest rate, which is known now. r 1 , 1 is the one-year spot rate that takes place one year from now, which will not be known until one year later. Expectation hypothesis not popular anymore. Liquidity hypothesis: f t,k = E [ r t,k ] + t , a premium is added if you promise to take on interest rates in the future....
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This note was uploaded on 01/19/2011 for the course 15 15.407 taught by Professor Wang during the Fall '03 term at MIT.

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03rec7 - 15.407 Recitation November 5, 2003 MIT Sloan...

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