Question #19

The swap spread is the spread between the fixed-rate on a market-rate swap and the Treasury rate on a similar maturity note/bond. Since the fixed rate is calculated from the reference rate yield curve, it is increased as the credit spread embedded in the reference rate yield curve increases. (Module 25.4, LOS 25.f) James Wallace, CFA, is a fixed income fund manager at a large investment firm. Each year, the firm recruits a group of new college graduates in the spring to enter in the firm's management training program. The program is a rigorous six-month course that exposes every candidate to each of the different departments within the firm. After successfully completing the six-month training period, candidates then receive offers for employment in one of the departments within the investment firm. Recently, Wallace was selected by his boss to teach the fixed income portion of the firm's training program. He will be able to hold several two-hour sessions with the new hires over a two-week time period, during which he is expected to instruct the trainee's on all aspects of fixed income analysis. These sessions serve as preparation for the trainees to be able to complete a month long rotation on the fixed income trading desk. His first few sessions will cover the core concepts of fixed income investing. Wallace believes that in order to fully grasp the more complicated concepts of fixed income analysis, the new hires must first begin by having a complete knowledge of the term structure and the volatility of interest rates. The new hires each have different educational backgrounds and varying amounts of work experience, so Wallace decides to begin with the most very basic concepts. He wants to start by teaching the various theories of the term structure of interest rates, and the implications of each theory for the shape of the Treasure yield curve. To evaluate the trainees' understanding of the subjects at hand, he creates a series of questions. The following interest rate scenario is used to derive examples on the different theories used to explain the shape of the term structure and for all computational problems in Wallace's lectures. Table 1 LIBOR Forward Rates and Implied Spot Rates Period LIBOR Forward Rates Implied Spot Rates 0 × 6 5.0000% 5.0000% 6 × 12 5.5000% 5.2498% 12 × 18 6.0000% 5.4996% 18 × 24 6.5000% 5.7492% 24 × 30 6.7500% 5.9490% 30 × 36 7.0000% 6.1238% James uses a rounded day count of 0.5 years for each semi-annual period.