Chapter 8 - Chapter 8 The Term Structure and Volatility of...

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1 Chapter 8 – The Term Structure and Volatility of Interest Rates 1. The Yield curve has taken on 3 fundamental shapes: 1. Normal, Flat and Inverted 2. Parallel, Non-Parallel, Twist and Curvature of the Yield Curve 1. Parallel Yield Curve Shift 2. Nonparallel Yield Curve Shift 3. Nonparallel – Butterfly Shifts 1. A positive butterfly means that the yield curve has become less curved & a negative butterfly means that there is more curvature to the yield curve 3. Factors that have been observed to drive Treasury security returns and the importance of each factor 1. Changes in the level of interest rates (parallel shifts in the yield curve) 1. Explains 90% of observed variation in total returns for all maturity levels 2. Changes in the slope of the yield curve (twists in the yield curve) 1. Explains 8.5% of observed variation in total returns 3. Changes in the curvature of the yield curve (butterfly shifts) 1. Explains 1.5% observed variation in total returns 4. Various universes of Treasury securities that are used to construct the theoretical spot rate curve, and discuss their advantages and disadvantages 1. All on-the-run Treasury securities (refers to newest treasury issues, bill, notes and bonds) 1. Adv: uses only the most accurately priced issues 1. The bootstrapping methodology can be used to generate a theoretical spot curve 2. Disadvantages: Large maturity gaps after the 10year note
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2 Chapter 8 ….contd 1. All on-the-run and some off-the-run treasury securities
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Chapter 8 - Chapter 8 The Term Structure and Volatility of...

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