This preview shows pages 1–5. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
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 oneyear 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....
View
Full
Document
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.
 Fall '03
 Wang

Click to edit the document details