51
CHAPTER 10
THE TERM STRUCTURE AND
INTEREST RATE DYNAMICS
PROBLEMS
1. Given spot rates for one-, two-, and three-year zero coupon bonds, how many forward
rates can be calculated?
2. Give two interpretations for the following forward rate: e two-year forward rate one
year from now is 2%.
3. Describe the relationship between forward rates and spot rates if the yield curve is at.
4. A. Define the yield to maturity for a coupon bond.
B. Is it possible for a coupon bond to earn less than the yield to maturity if held to
maturity?
5. If a bond trader believes that current forward rates overstate future spot rates, how might
he or she profit from that conclusion?
6. Explain the strategy of riding the yield curve.
7. What are the advantages of using the swap curve as a benchmark of interest rates relative
to a government bond yield curve?
8. Describe how the Z-spread can be used to price a bond.
9. What is the TED spread and what type of risk does it measure?
10. According to the local expectations theory, what would be the difference in the one-
month total return if an investor purchased a five-year zero-coupon bond versus a two-
year zero-coupon bond?
11. Compare the segmented market and the preferred habitat term structure theories.
12. A. List the three factors that have empirically been observed to affect Treasury
security returns and explain how each of these factors affects returns on Treasury
securities.
B. What has been observed to be the most important factor in affecting Treasury returns?
C. Which measures of yield curve risk can measure shaping risk?
52 Part I: Learning Objectives, Summary Overview, and Problems
13. Which forward rate cannot be computed from the one-, two-, three-, and four-year spot
rates? e rate for a:
A. one-year loan beginning in two years.
B. two-year loan beginning in two years.
C. three-year loan beginning in two years.
14. Consider spot rates for three zero-coupon bonds: r(1) = 3%, r(2) = 4%, and r(3) = 5%.
Which statement is correct? e forward rate for a one-year loan beginning in one year
will be:
A. less than the forward rate for a one-year loan beginning in two-years.
B. greater than the forward rate for a two-year loan beginning in one-year.
C. greater than the forward rate for a one-year loan beginning in two-years.
15. If one-period forward rates are decreasing with maturity, the yield curve is most likely:
A. at.
B. upward-sloping.
C. downward sloping.
e following information relates to Questions 16–29
A one-year zero-coupon bond yields 4.0%. e two- and three-year zero-coupon bonds yield
5.0% and 6.0% respectively.
16. e rate for a one-year loan beginning in one year is closest to:
A. 4.5%.
B. 5.0%.
C. 6.0%.
17. e forward rate for a two-year loan beginning in one year is closest to:
A. 5.0%
B. 6.0%
C. 7.0%
18. e forward rate for a one-year loan beginning in two years is closest to:
A. 6.0%
B. 7.0%
C. 8.0%
19. e five-year spot rate is not given above; however, the forward price for a two-year
zero-coupon bond beginning in three years is known to be 0.8479. e price today of a
five-year zero-coupon bond is closest to:
A. 0.7119.
B. 0.7835.
C. 0.9524.
20. e one-year spot rate r(1) = 4%, the forward rate for a one-year loan beginning in one
year is 6%, and the forward rate for a one-year loan beginning in two years is 8%. Which
of the following rates is closest to the three-year spot rate?
A. 4.0%
B. 6.0%
C. 8.0%
21. e one-year spot rate r(1) = 5% and the forward price for a one-year zero-coupon bond
beginning in one year is 0.9346. e spot price of a two-year zero-coupon bond is closest to:
A. 0.87.
B. 0.89.
C. 0.93.
Chapter 10 e Term Structure and Interest Rate Dynamics 53
22. In a typical interest rate swap contract, the swap rate is best described as the interest rate
for the:
A. fixed-rate leg of the swap.
B. oating-rate leg of the swap.
C. difference between the fixed and oating legs of the swap.
23. A two-year fixed-for-oating Libor swap is 1.00% and the two-year US Treasury bond is
yielding 0.63%. e swap spread is closest to:
A. 37 bps.
B. 100 bps.
C. 163 bps.
24. e swap spread is quoted as 50 bps. If the five-year US Treasury bond is yielding 2%, the
rate paid by the fixed payer in a five-year interest rate swap is closest to:
A. 0.50%.
B. 1.50%.
C. 2.50%.
25. If the three-month T-bill rate drops and the Libor rate remains the same, the relevant
TED spread:
A. increases.
B. decreases.
C. does not change.
26. Given the yield curve for US Treasury zero-coupon bonds, which spread is most helpful
pricing a corporate bond? e:
A. Z-Spread.
B. TED spread.
C. Libor–OIS spread.
27. A four-year corporate bond with a 7% coupon has a Z-spread of 200 bps. Assume a at
yield curve with an interest rate for all maturities of 5% and annual compounding. e
bond will most likely sell:
A. close to par.
B. at a premium to par.
C. at a discount to par.
28. e Z-spread of Bond A is 1.05% and the Z-spread of Bond B is 1.53%. All else equal,
which statement best describes the relationship between the two bonds?
A. Bond B is safer and will sell at a lower price.
B. Bond B is riskier and will sell at a lower price.
C. Bond A is riskier and will sell at a higher price.
29. Which term structure model can be calibrated to closely fit an observed yield curve?
A. e Ho–Lee Model
B. e Vasicek Model
C. e Cox–Ingersoll–Ross Model